CBO report: a thriller, with a bad ending

Congressional Budget Office's long-term budget outlook reads like a very scary document. Unfortunately, it's also too optimistic.

Every couple years, the Congressional Budget Office publishes a very scary document, The Long-Term Budget Outlook. As in previous reports, the conclusion is that a continuation of current policies would lead to an unsustainable increase in the national debt.

Here’s how you read the report. CBO simulates two scenarios. One is called “extended baseline,” in which all of the Bush tax cuts expire on schedule after 2012, the AMT engulfs the middle class in a web of higher taxes and mind-numbing complexity, and payments to providers under Medicare are slashed. While all of these things are technically scheduled to occur under current law, none is likely. Congress recently extended the Bush tax cuts, the AMT “patch” (which protects most middle class people from the dread tax), and the Medicare “doc fix,” and is likely to do so again.

The “alternative fiscal scenario” assumes that federal tax revenues return to their historical levels (18.4% of GDP) and health care spending continues to grow at roughly its historical rate (2 percentage points faster than GDP). The alternative scenario should really be labeled “current policy,” and it’s pretty bleak, as shown in the chart above (from the cover of the CBO report). Within 10 years, debt will exceed 100% of GDP. By 2037, it would be more than double the size of the economy.

That scenario, as dreadful as it is, is wildly over-optimistic, because it doesn’t account for the effect of rising debt levels on interest rates and the economy. In recent years, CBO has gotten more forceful in explaining this point. I’ll quote from the summary:

CBO’s projections in most of this report understate the severity of the long-term budget problem because they do not incorporate the negative effects that additional federal debt would have on the economy, nor do they include the impact of higher tax rates on people’s incentives to work and save. In particular, large budget deficits and growing debt would reduce national saving, leading to higher interest rates, more borrowing from abroad, and less domestic investment—which in turn would lower income growth in the United States. Taking those effects into account, CBO estimates that under the extended-baseline scenario, real (inflation-adjusted) gross national product (GNP) would be reduced slightly by 2025 and by as much as 2 percent by 2035, compared with what it would be under the stable economic environment that underlies most of the projections in this report. Under the alternative fiscal scenario, real GNP would be 2 percent to 6 percent lower in 2025, and 7 percent to 18 percent lower in 2035, than under a stable economic environment.

Rising levels of debt also would have other negative consequences that are not incorporated in those estimated effects on output:

• Higher levels of debt imply higher interest payments on that debt, which would eventually require either higher taxes or a reduction in government benefits and services.
• Rising debt would increasingly restrict policymakers’ ability to use tax and spending policies to respond to unexpected challenges, such as economic downturns or financial crises. As a result, the effects of such developments on the economy and people’s well-being could be worse.
• Growing debt also would increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget and the government would thereby lose its ability to borrow at affordable rates. Such a crisis would confront policymakers with extremely difficult choices. To restore investors’ confidence, policymakers would probably need to enact spending cuts or tax increases more drastic and painful than those that would have been necessary had the adjustments come sooner.

If you’d like to see a graphic description of the “sudden fiscal crisis” scenario, see my article, ”Countdown to Catastrophe.” It’s terrifying.

Back to CBO, the obvious conclusion (at least if you’re not a lawmaker):

To keep deficits and debt from climbing to unsustainable levels, policymakers will need to increase revenues substantially as a percentage of GDP, decrease spending significantly from projected levels, or adopt some combination of those two approaches. Making such changes while economic activity and employment remain well below their potential levels would probably slow the economic recovery. However, the sooner that medium- and long-term changes to tax and spending policies are agreed on, and the sooner they are carried out once the economy recovers, the smaller will be the damage to the economy from growing federal debt. Earlier action would permit smaller or more gradual changes and would give people more time to adjust to them, but it would require more sacrifices sooner from current older workers and retirees for the benefit of younger workers and future generations.

Translation: big tax increases or spending cuts right now would be a bad idea given the fragile state of the economy, but committing to serious debt reduction that will take effect once the economy has recovered is urgent if we are to avoid a budget catastrophe.

For fun, I looked at the first edition of the long-term budget outlook from 2000. It may surprise some readers that we were worried about long-term fiscal trends more than a decade ago, but independent budget analysts and the CBO recognized that rising health care costs and the aging of the baby boomers would put enormous pressure on the federal government. Of course, the fiscal situation seemed much brighter back in 2000. The economy was running surpluses and CBO was projecting them continuing for many years. So CBO’s discussion was about what we should do with the surpluses:

The aging of the large baby-boom generation and growth in the cost of health care will dramatically increase spending for federal health and retirement programs under current law. If policymakers act to ensure that the budget remains in surplus over the near term, the resulting drop in debt held by the public and the lower interest costs that follow will help offset some portion of that increase. Preserving the full amount of the projected surpluses could substantially delay the onset of fiscal problems and help boost GDP, providing a larger base of resources from which to meet the increased demand for spending. But even if policymakers preserved all projected surpluses, spending and revenues would be unlikely to balance over the next 75 years.

When the stock market bubble burst in 2000, the projected surpluses vanished too so there was no surplus to save. CBO’s 2000 analysis would seem to suggest that reducing deficits would be a matter of some urgency even then, but instead we enacted a series of large tax cuts and increased spending on national security, Medicare, and, later, economic stimulus.

Which explains why the current report has a much stronger sense of urgency.

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