Weekend Economists Sit on a Wall August 23-25, 2013

[Demeter]

50. Why the CBO's Deficit Forecasts Are Too Optimistic

http://www.bloomberg.com/news/2013-08-01/why-the-cbo-s-deficit-forecasts-are-too-optimistic.html

There's an old joke about a physicist, a chemist and an economist stranded on a desert island. A can of soup washes up on the beach. The physicist says, "Use a rock to smash it open." The chemist says, "Put it on the fire and let the heat burst it open." The economist says, "Assume a can opener."

In its forecasts of budget deficits, the Congressional Budget Office is assuming a can opener: Starting in 2015, it says, three straight years of 4 percent growth in real gross domestic product will get the U.S. out of its fiscal troubles (see chart).



Source: Congressional Budget Office

Is this any more plausible than the castaway's suggestion? The U.S. hasn't seen sustained growth at that rate since the boom of the late 1990s. Yesterday's GDP report confirmed that the economy is still only creaking along, with growth below 2 percent for the last three quarters. The CBO's forecasts are far too rosy by anyone's standards. Even the Fed, which has been wrongly optimistic for several years running, thinks growth will be slower than the CBO. Private forecasters surveyed by Bloomberg expect growth to run no higher than 3 percent.

Few would accuse the CBO of partisan bias or wishful thinking: It's a much-respected, independent agency. No, the problem is its economic model. Built into this is an assumption that the economy will eventually close the gap between what it's producing and its potential. This output gap now stands at 2.7 percent of GDP, according to the CBO. That assumption is probably wrong. I'm sure they know, and I think they're at fault for not being forthright about it. Economists expect that the U.S. will continue its economic rebound. A decent number think the recovery will accelerate. But a boom sufficient to recoup all of the lost production? Stop, you're making them laugh.

You know who's not laughing, though? The people who realize that, when you drop that unreasonable assumption, the outlook for the budget looks much worse. A rule of thumb, according to the CBO, is that for every 1 percent increase in GDP, federal revenues also rise by 1 percent, or $30 billion. Suppose the output gap doesn't close: Slower growth in revenues would imply a future budget deficit that is roughly 1 percent of GDP bigger. A weaker expansion would mean higher government spending, too, also expanding the deficit. The CBO has already revised its view of the economy's long-run rate of growth: It now puts this at just 2.2 percent. And the recession caused it to drop its estimate of current potential GDP by roughly 3 percent. Even so, its view on the closing of the output gap still puts an unduly positive spin on the prospects.

The point has received too little attention -- though it hasn't gone entirely unnoticed. Deficit doves and hawks alike have expressed concern. Paul Krugman noted the issue on his blog a while back, writing "No, I don’t know where that recovery in 2015 is supposed to come from." As did John H. Cochrane, an economist who has clashed with Krugman in the past. "The real budget news that could matter has little to do with tax rates or spending," Cochrane wrote. "What matters most of all is whether we break out of this sclerotic growth trap."

Each year the CBO pushes the closing of the output gap a little further into the future. Eventually it will have to admit that its expected burst of catch-up growth is nowhere in sight. When it does, its budget forecasts will darken once again.