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The Twelve Takeaways from CBO’s 2012 Budget and Economic Outlook

Kevin McGrath contributed to this post.

The Congressional Budget Office (CBO) has released its ten-year budget and economic prospectus, “The Budget and Economic Outlook: Fiscal Years 2012 to 2022.” This is CBO’s annual report to Congress on the state of the U.S. economy and the federal budget, and it forms the starting point for the year’s budget discussions.

Without further ado, let’s take a look at the top 12 takeaways from last week’s release roughly ordered by starting from the immediate economic conditions and moving out to the long-term debt trajectory:

1. The economic recovery remains sluggish. Modest economic growth in the fourth quarter of calendar year 2011 ? real gross domestic product (GDP) rose by 2.8 percent ? means the recovery is progressing, but slowly. CBO roughly projects this trend to continue, with 2.0 percent GDP growth forecast for 2012.

This relatively tepid growth reflects the lingering consequences of the financial crisis and recession ? a battered housing market, losses in private wealth, and immense personal debt all continue to weigh on consumer spending. Largely as a result of these poor economic conditions, inflation and interest rates are projected to remain low in the coming years.

The report predicts that, on the economy’s current trajectory, output will remain below its potential until 2018. Production below capacity for such an extended period was last seen during the Great Depression ? an indubitably ominous sign.


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2. Unemployment remains intractable, and CBO projects that gains will remain slow. CBO does not forecast the unemployment rate to drop below 8 percent this year. Alarmingly, alternative measures of joblessness that incorporate discouraged and part-time workers remain significantly higher, suggesting that many people either have stopped looking for work or settled for working fewer hours than desired. The labor market still has a tremendous amount of slack. Unemployment is not projected to return to near full employment ? or 5.5 percent ? until 2018.

The Great Recession therefore would be the longest period of persistent high unemployment in the U.S. since the Great Depression and could have significant consequences on output over time, depending on how firms and workers react. This type of elevated long-term unemployment carries great risks ? such as a deteriorating skill-set among the labor force ? that could reduce long-term production in the economy.


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3. The “blue-chip consensus” projections for the unemployment rate originally overestimated the strength of the recovery, but recently appear to be erring on the pessimistic side. Bottom line: These figures are difficult to predict. Carmen Reinhart and Ken Rogoff anticipated the extended economic stagnation in their recent work, “This Time Is Different.” They describe how economic downturns caused by financial collapse do not produce typical, short-lived recessions. In these crisis situations, the economy often remains depressed for a long period of time, and recovery is elusive.

Initially, most forecasters did not adhere to the Reinhart and Rogoff findings in their predictions for the speed of the current recovery. Adjusting to the fact that we were in a “different” situation has taken quite some time, and only recently have CBO’s projections shown that unemployment will remain high for an extended period.

(Note: Based on economic data released since CBO completed its latest projections, some commentators now believe that the economy may perform stronger than those indicate. In fact, in the graph below, CBO’s 2010 projections nearly match recent unemployment data.)


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4. Our current budget deficit remains enormous ? $1.079 trillion, to be exact, or 7 percent of GDP for fiscal year (FY) 2012. CBOeight.jpg

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5. Unrealistically, CBO’s current law baseline shows deficits shrinking dramatically over the next few years. Reader beware: this projection contains many policy assumptions that are far from assured, including expiration of the 2001, 2003, and 2010 tax cuts, implementation of the Budget Control Act (BCA) sequester cuts, and failure to renew the alternative minimum tax (AMT) “patch” and the “doc fix.” In CBO’s words, the current law baseline represents a “benchmark against which fiscal changes can be measured,“ it should not be considered a serious forecast.

The implementation of these spending cuts and expiration of these tax cuts, paired with the winding down of the 2009 stimulus, would represent what CBO Director Douglas Elmendorf calls a “sharp fiscal contraction” ? $400 billion-worth in one year. This combination of drastic, immediate spending cuts and tax increases would reduce growth significantly in 2013, according to the report, and could choke off the nascent recovery.

On the other hand, here’s what deficits would look like, all else equal, if those policies were reversed: CBOfour_0.jpg

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6. The looming sequester would cut spending in the short and medium term, but does little to address the long-term debt situation. We have examined the mechanics and effects of the sequester in some depth (see here), and it is scheduled to cut over $1 trillion in spending over the next nine years. Beyond interest savings, the cuts will be evenly split between defense and non-defense programs that are not explicitly exempt. The graph below shows the sequester’s effect on the debt trajectory. The bottom line is that the cuts produce a lot of pain for very little gain.


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7. Under current law (i.e., the sequester takes effect), both defense and domestic (non-defense) discretionary spending will be reduced to their lowest levels in the last half century as a percentage of the economy. The Budget Control Act of 2011 (BCA) already imposed caps on discretionary spending that would cut approximately $800 billion over the decade. The Department of Defense and other government agencies will require substantial reforms just to comply with the original BCA caps on spending. The sequester would cut roughly another $750 billion from these accounts over the same period, requiring reforms that many believe would be dangerous for defense and destructive to national investments.

When combined, these cuts will reduce discretionary budget authority in fiscal year 2013 by approximately 15 percent from CBO’s January 2011 baseline, indiscriminately slashing both defense and non-defense discretionary spending.


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8. Under what many would consider to be CBO’s “more realistic” scenario, deficits will remain close to or above $1 trillion in each of the next ten years. As mentioned above, the current law baseline incorporates a host of assumptions that most outside observers find unlikely to occur. In the words of Director Elmendorf:

“As the last few years have gone on, and more and more aspects of the budget have either been enacted or extended on a temporary basis, we felt that the current law baseline provides a less and less useful guide to what the current stance of fiscal policy is.”*

CBO has constructed an alternative fiscal scenario (AFS) to roughly simulate the future budget situation if Congress conducts business as it has in the past ? extending certain tax cuts and obviating particular spending cuts. This budget path is drastically different from the one under current law.** The policy assumptions in the AFS are projected to produce deficits totaling $11 trillion for the coming decade, versus $3 trillion using current law.

CBO Report Analysis 7.jpg

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9. Within the decade ? if current policies stay in place ? revenues will return to their historical levels, but not beyond. Even if the 2001, 2003, and 2010 tax cuts are extended, as they are in the AFS, revenues are projected to rise from 16.1 percent of GDP in 2012 to 18.0 percent in 2017, and then remain roughly at that level for the remainder of the decade. This approximates the average U.S. revenue level in the modern era.

In times of better fiscal health, such receipts might have been sufficient, but the coming decades do not fit the bill. First, our public debt is already at 72 percent of GDP ? higher than it has been in over half a century ? and projected to increase further. Second, a wave of baby boomers are beginning to descend on the entitlement programs, and supporting them in retirement will require additional spending even if significant reforms are made to control costs. Between these two trends, we will not be able to collect revenues at “normal” levels if we want to have a sustainable budget and a functioning economy.

The four balanced budgets in recent times have come at revenue levels between 19.5 and 20.6 percent of GDP. We will need to at least enter that range if we hope to stabilize the debt, particularly with the demographic tidal wave that inevitably will add a heavy burden to the federal budget.


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10. Healthcare spending remains the primary long-term driver of U.S. debt. This is the fundamental challenge of the coming decades, stemming from the rising cost of providing health care and the aging of the population.

Even with savings from the Affordable Care Act (ACA), healthcare costs per capita are projected to continue growing significantly faster than the economy ? an unsustainable course. Additionally, with the retirement of the baby boomers, Medicare will face a flood of new beneficiaries over the next few decades. The number of Americans aged 65 or older is expected to increase by one-third by 2022.

These facts combine to produce one of the most compelling displays of the nation’s fiscal problems. Healthcare spending is the only part of the budget that is projected to grow relative to the size of the economy ? and grow it does: from 5 percent of GDP this year to 12.4 percent of GDP by 2052. Curbing this line is a necessity for any viable debt reduction package.


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11. The outlook for Social Security has worsened substantially. The fact that Social Security requires reforms in order to remain solvent comes as no surprise ? both the president’s fiscal commission and BPC’s Domenici-Rivlin Task Force reaffirmed this in their reports. Many people may be unaware, however, that CBO’s latest projections are even more dire than they were as recently as last year.

Reforms were made during the 1980s, including the gradual increase in the full retirement age from 65 to 67, to prepare the program for the retirement of the Baby Boom generation. This resulted in a buildup of the Social Security Trust Fund over the ensuing decades, so that it could be drawn down to pay benefits as the baby boomers progressed through retirement, thereby maintaining the underlying solvency of the program. Unfortunately, those reforms appear to have been insufficient.

As of last year, the Social Security Trustees projected that the Trust Fund would be exhausted by 2036, and at that point would no longer have sufficient funds to pay out full benefits to beneficiaries on the strength of payroll taxes. In a frightening turn of events, the data in this year’s CBO report appear much worse, indicating that the Trust Fund could be bankrupt within two decades!

? CBOsix_0.jpg

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12. On its current path, public debt will exceed the size of our economy by 2027 and continue to explode thereafter. There are consequences and risks to carrying such a large national debt. At some point, it will begin to crowd out private investment and retard economic growth. Moreover, at these debt levels, policymakers will have significantly less flexibility to respond to national emergencies or changing economic conditions.

Director Elmendorf has stated that “there is no plausible economic outcome under which [this policy path] would lead to a sustainable budget.” In other words, the U.S. cannot grow its way out of this problem. Congress and the President will have to make the tough decisions to bring down our debt burden.

Demonstrating just how large our fiscal gap is, the federal government would need savings of over $750 billion in the year 2022 to have debt steady relative to GDP at that point.*** Debt held by the public is on track to equal roughly $21 trillion, or 86 percent of GDP, by the end of the projection window in 2022.**** This would be by far the highest level since World War II, and a dangerous position for the country, particularly with no end in sight.


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All told, there is little new in the picture painted today by CBO. The economy is growing, but slowly, and it will take quite some time to pick up the slack in the labor market. Spending will continue to rise (in part, due to the inevitable retirement of the baby boomers), revenues will fail to keep pace, and therefore the deficit and debt will continue to grow. Because of the difficult position we’re in ? rising deficits, a weak economy, and a changing workforce ? the time is ripe for serious, thoughtful reforms to our national commitments. As Director Elmendorf has stated, the ideal fiscal policy would enact legislation now that both widens deficits in the near term, and closes them in later years. He put it best when he said:

“Very sharp imposition of fiscal restraint?under the current economic conditions, in particular, will tend to hold back the economy. At the same time, letting debt skyrocket?will ultimately be very, very damaging to the economy and unsupportable. So, one can both provide short-term support and put the economy on a?sustainable medium-term to long-term path. There is no intrinsic contradiction, but to do that requires that fiscal restraint take effect slowly and amount to very large changes by the end of the decade.” [emphasis ours]

We have a long-run debt problem that policymakers need to start addressing now, in tandem with our immediate economic problems. Waiting to decide what policy changes we will make only has downsides ? greater uncertainty, and a growing debt burden among them.

Growth, healthcare cost restraint, and tax reform are three critical components to a formula of economic strength. Here’s to hoping that our political leaders can put aside their differences and pursue them together.

* Links are to Director Elmendorf’s February 2012 testimony before the House and Senate Budget Committees. Some of the direct quotes in the post are oral remarks from those hearings, and cannot be found in the text of his statement.

** Unlike current law, the AFS assumes that the 2001, 2003, and 2010 tax cuts are extended, the AMT is indexed to inflation, Medicare’s physician payment rates are maintained at their current rate (the “doc fix”), and the looming sequester from the Budget Control Act of 2011 (BCA) is lifted. BPC’s Plausible Baseline incorporates all of these assumptions, and also that troops stationed overseas decline to 45,000 by 2015. *** $750 billion of savings in a particular year is gigantic. For reference, the sequester saved $1 trillion over ten years, but only approximately $100 billion in each year. The 2022 savings to stabilize the debt would have to be substantially larger.

**** This projection uses BPC’s “plausible” baseline, which is based on the AFS and incorporates the additional assumption that the U.S. will gradually drawdown its troops that are engaged in overseas operations.

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