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Up Front

CBO’s New Budget Projections: Not Chicken Little, But Not Mission Accomplished Either

CBO’s release of new budget projections earlier today provides an opportunity to take stock of fiscal situation facing the country. At the risk of oversimplifying, the report contains one piece of good news, two of bad news. Neither a “chicken little” nor a “mission accomplished” view is validated.

The good news is that current annual budget deficits are at very reasonable levels, relative to the size of the economy. The deficit will be about 2.6 percent of GDP in 2015, CBO says, a figure that is both manageable and much lower than even just a few years ago. The decline in the deficit over the past few years can be attributed to many factors, most notably the economic recovery, but also the budget deal in 2011 and the tax increases that took place in 2013. Those policies may not have been well-advised from a short-term stimulus perspective, but they have helped reduce the deficit.

The first piece of bad news is that the high deficits of recent years have boosted the current stock of public debt to all-time peace-time highs relative to the size of the economy. The debt-GDP ratio stands at 74 percent currently, up from an average of 37 percent in 1957-2007, the 50 years before the Great Recession, and a value of 35 percent as of 2007. The only time in U.S. history that the debt-GDP ratio has been higher is during and just after World War II, when the massive mobilization effort raised debt to more than 100 percent of GDP.

We know why we have that increase. The increase in debt-GDP was due largely to the Great Recession, which depressed revenues, and to a much smaller extent to the stimulus package.

The current high level of debt is not a crisis by any means. We are not Greece or even close. We do not need immediate cuts in spending or tax increases; indeed, they would probably be harmful to overall growth, as the economy is still in recovery mode. But the high debt level is not good news, and it is a problem to keep an eye on.

In the past, when we have had high debt peaks (after the Civil War, World War I, and World War II), we have paid down approximately half as a share of GDP in 10-15 years — through a combination of budget cuts, inflation, and economic growth.

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And that brings us to the second problem highlighted in the CBO report. The debt-GDP ratio is not projected to fall in half over a decade; rather, it is projected to be constant for about five years, and then to start gradually rising again. So, we are entering new territory – permanently high and potentially rising debt-GDP ratios.

There are at least three ways to see that this creates long-term problems for the economy.

First, countries have historically avoided debt-GDP ratios as high as we have now whenever they could. Wars, depressions, or financial crises are generally the only reasons why countries end up as indebted as the U.S. government. If it were costless to have such high debt-GDP ratios, countries would be clamoring to reach those levels, since doing so would let them cut taxes or raise spending with abandon. Before the financial crisis, for example, only one of 30 OECD countries, Italy (with a history of fiscal problems) had higher debt-GDP ratios than we do now. (To make this comparison on an apples-to-apples basis, you have to compare debt at all levels of government.)

Second, in long-term models of economic growth, higher levels of debt reduce growth by crowding out other capital accumulation. Illustrative calculations by Douglas Elmendorf and Greg Mankiw suggest that raising the national debt by 50 percent of GDP reduces net output by more than 3 percent. A study by IMF researchers finds that a higher initial debt-GDP ratio of 10 percentage points reduces growth by in subsequent years by 0.15 percentage points.

It is worth noting that CBO’s long-term growth rate, 2.5 percent, was revised downward in this most recent report, and is significantly lower than the rates experienced in the 1980s and 1990s. Much of the decline is due to projected slow growth in the labor force, but a big debt overhang does not help.

Third, if we want to cut the debt-GDP ratio in half, which would get us back to historically typical ground, it will require a major adjustment of policy, even if we give ourselves 25 years to get there, rather than the 10-15 years it has taken in previous consolidations. Estimates I have done with Alan Auerbach suggest that we would need immediate and permanent policy adjustments – tax increases or spending cuts – exceeding 3 percent of GDP. If we wait five years to implement the cuts, they would need to be almost 4 percent of GDP.

There is no denying that substantial fiscal progress has been made in the last few years. But there is equally no denying that we still have a ways to go in the long-term. The CBO report helps frame this middle ground. How policy makers respond is a different question.

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