Yves here. We’ve written from time to time about the shameless partisan role that the Congressional Budget Office plays in stoking misguided and destructive concern about budget deficits. It’s important to recognize the CBO’s openly partisan stance on this issue, because it is supposed to make independent, apolitical budget forecasts and is widely and mistakenly seen as “objective”. In fact, the CBO’s regularly takes stances that put them in the same camp as billionaires like Pete Peterson and Stan Druckenmiller, who want to slash Social Security and other social safety nets.
In fact, as we detailed in a 2012 post, the CBO departed wildly from clearly stipulated procedures for preparing long-term budget analyses to cook up projections that showed Medicare costs continuing to grow markedly faster than is remotely plausible. This mattered because health care cost increases are the driver of long-term budget worries. The CBO’s analysis was so dubious that two budgetary experts at the Fed published a devastating paper on the CBO analysis. From our post:
A remarkably important and persuasive paper that calls into question the need for “reforming” Medicare has not gotten the attention it warrants. “An Examination of Health-Spending Growth In The United States: Past Trends And Future Prospects” (hat tip nathan) by Glenn Follette and Louise Sheiner looks at the model used by the Congressional Budgetary Office to estimate long term health care cost increases. Bear in mind that this model is THE driver of virtually all forecasts of future budget deficits.
This paper, although written in typically anodyne economese, is devastating in the range and nature of its criticisms….
The fundamental beef of Follette and Sheiner with the CBO model is that it naively assumes past growth in health care spending as the basis for its long-term projections. The result is that it shows that trees will grow to the sky. One of the things anyone who has built forecasting models will tell you is you come up with assumptions that look reasonable and then sanity check the output (for instance, does your model say in year 10 that your revenues will be 3x what you can produce given your forecast level in plant and investment? If so, you need to make some revisions). The Fed economists point out numerous ways that the model output flies in the face of what amounts to common sense in the world of long term budget forecasting. From the opening of the paper (emphasis ours):
Long-run projections of the U.S. federal budget have played a prominent role in discussions about fiscal policy and the design of major transfer programs for several decades. The projections typically show large fiscal imbalances owing to ramping up of retirement and health care costs relative to GDP. Health care costs are the key factor in these projections for two reasons. First, in current projections they are the prime source of growth of spending as a share of GDP. Second, they are the most uncertain part of the forecast. For example, the Congressional Budget Office’s most recent long run outlook shows spending on Medicare and Medicaid, the governments health programs for the old and poor, respectively, rising from 4.1 per cent of GDP in 2007 to 19.1 per cent of GDP in 2082.1 By contrast, Social Security benefits (the government’s main old-age pension program) increase only 2 percentage points, from 4.3 per cent of GDP in 2007 to 6.4 per cent in 2082. Another analysis by CBO suggests that an 80 per cent confidence band around the Social Security projection would be from 51⁄2 to 91⁄2 per cent of GDP.2 CBO did not present similar calculations for health spending; instead, they projected health spending under three different assumptions about the rate of growth of age-adjusted health care spending in excess of per capita income. Their projections show health spending ranging from 7 to nearly 40 per cent of GDP by 2082.
By comparison, defense spending as a percent of GDP peaked at 42% of GDP in World War II. A model that presents as a possible outcome that the US will devote nearly 40% of GDP to health care spending a long-term, sustained outcome, is ludicrous on its face. The CBO assuming public health care spending will sustain its growth rate of the last 50 years for as long as they do (see further discussion below) with no policy changes is like budget analysts in 1946 assuming that military spending will grow at the same rate it did during World War II without any policy changes. Yet they further assume that, having reached this crushing level, Medicare costs in 2082 will still be growing faster than GDP!
Back to the current post. This is far from the only example of the CBO operating in less than good faith. Back in the days when the Rogoff/Reinhardt “government debt/GDP in excess of 90% is really really bad” was taken seriously, the CBO produced a forecast showing that Federal debt to GDP reached 89.8% by 2022, enough to give the deficit hawks plenty of grist. But Tom Ferguson and Rob Johnson pointed out in a 2010 paper that the CBO had neglected to net out financial assets. If you did that, it took the debt/DGP ratio to a lever that the scaremongers could not depict as troublesome, 82%. As we noted in a 2012 post:
Having been alerted to the Ferguson/Johnson paper, “A World Upside Down: Deficit Fantasies in the Great Recession,” International Journal of Political Economy, Vol. 40 No. 2 (2011), has the CBO decided to deal honestly with the question? No. Like the mob faced with the prospect of a damaging witness testifying, it has done a hit job on the data. Its recent deficit discussions do not even reference this information. As Thomas Ferguson complained, “Talk about ‘Choices for Deficit Reduction.’ I finally found the numbers in an OMB report issued earlier this year. The CBO should be printing these right along with the gross debt; at least back in 2010, you could find them in the fine print of one or two CBO reports. Now not even a magnifying glass will help.”
Let us now turn to Scott Fullwiler’s latest sighting of how the CBO is playing an openly political role on this issue.
By Scott Fullwiler, Associate Professor of Economics and James A. Leach Chair in Banking and Monetary Economics at Wartburg College. Cross posted from New Economic Perspectives
The Congressional Budget Office (CBO) published its long-term deficit and national debt projections last week. These are the projections most widely cited in policy discussions about long-term “sustainability” of the national debt and entitlement programs. In this post I focus on a small but very important part of the report—the CBO’s discussion of the “Consequences of a Large and Growing Debt,” which can be found on pages 13-15. This section can be found in past reports going back several years, and hasn’t change much if it has changed at all during this time. It is also consistent with the thinking of most economists on these issues. As readers of this blog will recognize, the CBO’s analysis is “out of paradigm” in that it is inapplicable to a sovereign, currency-currency issuing government operating under flexible exchange rates such as the US, Japan, Canada, UK, Australia, etc.
CBO presents four consequences of a large and growing national debt. I discuss each in turn.
- Less National Saving and Future Income–Large federal budget deficits over the long term would reduce investment, resulting in lower national income and higher interest rates than would otherwise occur. Increased government borrowing would cause a larger share of the savings potentially available for investment to be used for purchasing government securities, such as Treasury bonds. Those purchases would crowd out investment in capital goods—factories and computers, for example—which makes workers more productive.
This would be laughable if it weren’t for the fact that most economists believe it and the dangers of following policy based on such a belief. The analysis is based on the loanable funds market—which DOES NOT EXIST in the real world. In reality, the funds that banks lend are created out of thin air, not constrained by saving, the flow of deposits, or fractional reserve requirements. Even a 100% requirement changes nothing as long as the central bank is targeting the interbank rate that sets the banks’ cost of funds. More reserves are always forthcoming via open market operations if the interbank rate starts to move above the central bank’s target, so there is no rise in interest rates of the sort that the loanable funds model supposes.
So there is no threat to funding available for private investment in capital goods, and no threat to the growth rate of future national income. CBO’s analysis is simply inconsistent with how the modern financial system actually works. (My post here from 2012 described the process of bank lending. For more detailed analysis of the interaction of banks and central banks, see here, here, here, and here.)
As an aside, consistent with neoclassical theory in which factors of production receive their marginal product, CBO writes that “because wages are determined mainly by workers’ productivity, the reduction in investment would reduce wages as well [since the investment is driving productivity of workers in CBO’s analysis], lessening people’s incentive to work.” Wow. Apparently CBO hasn’t noticed that (a) wages and productivity have diverged for the past 40 years, with productivity far outstripping wage growth, and (b) low wages haven’t lessened the incentive to work at all (if they did, US workers should be working far less than there French and German counterparts while the opposite is true). Three words—Cambridge Capital Controversies, which neoclassicals still haven’t actually bothered to understand. Instead they hide behind a theory that suggests CEOs making exponentially more than the average worker somehow “deserve” this excessive pay even as anyone that bothers to look can see that these same CEOs have led the private sector to far slower growth rates of productivity than we saw in the 1950s and 1960s when the ratio of CEO pay to worker pay was far smaller. But I digress. (And apologies for the rather simplistic analysis here—I realize there’s much more going on with wages—but again, this isn’t the main point of the post.)
- Pressure for Larger Tax Increases or Spending Cuts in the Future– When the federal debt is large, the government ordinarily must make substantial interest payments to its lenders, and growth in the debt causes those interest payments to increase. (Net interest payments are currently fairly small relative to the size of the economy because interest rates are exceptionally low, but CBO anticipates that those payments will increase considerably as interest rates return to more typical levels.)
In other words, when interest rates rise, they will take up a larger percentage of the government’s outlays, increasing the likelihood of future large deficits unless spending is cut or taxes are raised. Similarly, a desire to raise spending or cut taxes in the future will be thwarted by projections of even larger deficits and require still greater cuts or taxes elsewhere. CBO wants us to believe that it is just trying to protect us from the difficult political decisions this would bring.
In some ways this is a legitimate point, but I would say it differently. Any increase in the government’s deficit can result in greater aggregate spending on existing productive capacity, so if the government is sending more interest to bond holders, ceteris paribus, this is creating the potential for inflation. However, the issue here isn’t the larger deficits as much as it is the larger deficits relative to the inflation threat. But CBO presents us with no analysis of the future inflation threat of rising debt service—in fact, its long-term analysis assumes both an economy at full employment beginning a few years from now and very modest inflation throughout even with the larger deficit and debt service projections. In other words, the real danger of rising debt service or rising government deficits in general (aside from the obvious potential misallocation of the government’s spending) is assumed away by CBO from the start.
Furthermore, rising debt service for a currency-issuer under flexible exchange rates like the US is a monetary policy variable, as I explained here and here. If rising debt service is pushing the government’s deficit too high, CBO should explain to us why an inflation-targeting central bank is raising the risk of inflation by raising the government’s debt service.
In any case, an economy reaching the point at which a central bank running a Taylor Rule type of interest rate targeting strategy will raise rates should also be precisely when the government is experiencing fairly rapidly declining primary deficits (the deficit aside from debt service)–which is the case in the US’s history—and probably shouldn’t be entertaining thoughts of increasing deficits at that point if low and stable inflation is a serious policy goal. In most other cases, the central bank shouldn’t be raising rates and the government should be increasing its deficit. CBO’s assumption of continuous full employment and low inflation mistakenly abstracts from the fact that the real world economy is always in the midst of some stage of a business cycle.
- Reduced Ability to Respond to Domestic and International Problems–When the amount of outstanding debt is relatively small, a government can borrow money to address significant unexpected events—recessions, financial crises, or wars, for example. In contrast, when outstanding debt is large, a government has less flexibility to address financial and economic crises—a very costly circumstance for many countries. A large amount of debt also can compromise a country’s national security by constraining military spending in times of international crisis or by limiting the country’s ability to prepare for such a crisis.
This one’s pretty amazing—seriously, how can someone actually believe this stuff? First off, as we know, government’s that issue their own currencies don’t need to borrow back their own money. Second, even if you do think so, as above, the interest rate on this increase in the national debt is a monetary policy variable, not one that is set by markets. There is no danger of a currency issuing government not being able to finance its deficits in a time of crisis. And we know that times of war and financial crisis are in particular the times at which safe, default-risk free government debt is at its lowest rate of interest relative to the debt of non-currency issuers. Third, such crises are also the points at which the central bank typically has its policy rate—and by extension interest rates on the national debt—set at its lowest. In fact, it is the private sector that experiences such problems in these times, not the currency-issuing governments—just look back to how private credit markets responded to the global financial crisis of 2008-2009 for the most recent example.
The second part of CBO’s rationale here is even more ridiculous—did they not notice that times of war and financial crisis have been the times of most of the largest increases in the US national debt? Indeed, the real danger is that in a time of such crisis policy makers will actually believe analysis like CBO’s here. Thankfully, during WWII they didn’t. They didn’t listen after September 11, 2001. And they didn’t listen in 2008 (TARP) or 2009 (Obama stimulus—though the CBO-types did in fact keep the Obama stimulus insufficiently small, not that I was necessarily in favor of many of the spending priorities in the bill). And in every case of policy makers not listening, interest rates remained low while the government ran the deficits it wanted to run.
- Greater Chance of a Fiscal Crisis—A large and continuously growing federal debt would have another significant negative consequence: It would increase the likelihood of a fiscal crisis in the United States. Specifically, there would be a greater risk that investors would become unwilling to finance the government’s borrowing needs unless they were compensated with very high interest rates and, as a result, interest rates on federal debt would rise suddenly and sharply relative to rates of return on other assets. That increase in interest rates would reduce the market value of outstanding government bonds, causing losses for investors and perhaps precipitating a broader financial crisis by creating losses for mutual funds, pension funds, insurance companies, banks, and other holders of government debt—losses that might be large enough to cause some financial institutions to fail. Unfortunately, there is no way to predict with any confidence whether or when such a fiscal crisis might occur in the United States. In particular, there is no identifiable tipping point in the debt-to-GDP ratio to indicate that a crisis is likely or imminent. All else being equal, however, the larger a government’s debt, the greater the risk of a fiscal crisis.
Here we see the “US could become Greece” argument, with “we can’t say when it could become Greece, but we don’t want to find out!” added on. In fact, the CBO in the footnotes links to its 2010 report, “Federal Debt and the Risk of a Fiscal Crisis” (in which it makes the same four points as here, by the way, regarding the consequences of large and rising debt), which analyzes recent fiscal crises in Argentina, Ireland, and Greece and then considers how their difficulties dealing with rising interest rates on the national debt, diminished access to financial markets, etc., could harm the US economy.
Again, though, a currency-issuing government under flexible exchange rates can’t have such crises because it doesn’t need to borrow its money; interest rates on its debt are a monetary policy variable. The doomsayers have been at this for decades now, but have not explained why the US, UK, and Japan ran continually large deficits starting in 2008 at low interest rates while Greece, Spain, Italy, etc., could not. Their only response is, “Just wait! This time is NOT different!” At least CBO doesn’t fall into the typical trap of citing the Reinhart/Rogoff paper on “tipping points,” which has been discredited (see here and here as well). CBO simply notes here that as of yet “there is no identifiable tipping point”—this is true of course, since there isn’t a tipping point at all if it’s your own currency and you have the ability to set the interest rate on it. At some point one would think the “US could become Greece” argument would be widely recognized as fraudulent, but if you’re in the wrong paradigm it’s difficult to accept even a simple explanation of why the paradigm is wrong.
In the end, what we see from these four points made by CBO is that the real danger to policymakers isn’t large deficits and debt. The real danger is that they will pay attention to analysis done of large deficits and debt by CBO and others like it—such as most economists—and unfortunately they are all paying attention and echoing this same sort of analysis. And here we all sit in a six year trough relative to potential GDP, continued high unemployment (particularly if you include underemployment, etc.) and low participation rates, and with even fairly decent job creation that however is focused on the low-wage end compared to previous recoveries (see here). And this isn’t even to mention the Eurozone nations that are still in depression states.