Don’t Believe the Hype

On Wednesday, the Congressional Budget Office released updated projections for federal government deficits and debt over the next ten years. Some people may have been excited by what they read. The CBO essentially halved its estimate for cumulative budget deficits over the next 10 years. The ratio of total debt held by the public to GDP is now expected to be just 61% by 2021 compared to the prior estimate of 77%. Sounds great, right?

These projections need to be taken with a LARGE grain of salt. They are based on unrealistic assumptions about the future course of spending and fiscal policy. But before I get into that, let me summarize the report’s findings. The following statistics are based on the CBO’s baseline projections:
•The $1.3 trillion deficit projected for 2011 will be the third-largest shortfall in the past 65 years, exceeded only by the deficits of the preceding two years
•The deficit as a percentage of GDP will fall from 8.5% in 2011 to 1.1% in 2015
•Deficits as a percentage of GDP will average 1.2% from 2014 to 2021
•Cumulative deficits will total $3.5 trillion between 2012 and 2021 compared to the prior projection (March, 2011) of $6.7 trillion
•Debt held by the public will equal 61% of GDP at the end of 2021 compared to the prior projection (March, 2011) of 77%
•Real GDP will increase 2.3% in 2011 and 2.7% in 2012, and GDP growth will average 3.6% from 2013-2016 and 2.4% from 2017-2021
•The unemployment rate will stay above 8% through 2013, but will fall to 5.2% by 2017

Obviously, the halving of projected cumulative deficits over the next ten years to $3.5 trillion from $6.7 trillion is a positive development. According to the CBO, about two-thirds of the reduction is the result of the recent passage of the Budget Control Act. This hard-fought piece of legislation, which came at the last minute and averted a potential financial crisis, sets caps on future discretionary spending and creates a process for adopting additional deficit reduction measures. The remaining one-third of the reduction in cumulative deficits is the result of “changes in the economic outlook and technical revisions to CBO’s projections.”

Based on my comparison between the CBO’s March and August projections for the 2012-2021 time frame, there are three major changes that account for the approximately $3.2 trillion decrease in cumulative deficit. First, the CBO now expects $1.2 trillion in mandatory cuts resulting from the Budget Control Act. Second, the CBO now expects about $1 trillion less in discretionary spending resulting from additional cuts (also a result of the BCA). And finally, the CBO now expects about $1 trillion less in interest costs. These interest cost “savings” are the result of a combination of lower-than-expected interest rates and the aforementioned cuts in discretionary spending (relative to the previous projections).

Now, time to poke holes in these figures. First and perhaps most obviously, the CBO’s expectations for GDP growth in 2011 and 2012 (2.3% and 2.7%, respectively) may be wildly optimistic at this point. But at least they reduced these estimates somewhat from the March projections. More important than those figures is the 3.6% average GDP growth assumption the CBO is now using for the 2013-2016 time frame. If we believe Mohamed El-Erian’s theory that we are in a “new normal” environment in which growth will be weak for an extended period as the economy delevers (ie, pays down debt), these estimates may also be optimistic. And if GDP growth is less than expected, tax revenue is likely to be lower and government outlays are likely to be higher.

But even the GDP growth assumptions are minor compared to the BIG assumption that the Bush tax cuts are allowed to expire. The CBO states the following in its release:

“For example, if most of the provisions in the 2010 tax act that were originally enacted in 2001, 2003, 2009, and 2010 were extended (rather than allowed to expire on December 31, 2012, as scheduled); the alternative minimum tax was indexed for inflation; and cuts to Medicare’s payment rates for physicians’ services were prevented, then annual deficits from 2012 through 2021 would average 4.3 percent of GDP, compared with 1.8 percent in CBO’s baseline projections. With cumulative deficits during that decade of nearly $8.5 trillion, debt held by the public would reach 82 percent of GDP by the end of 2021, higher than in any year since 1948.”

Moreover, the CBO’s assumption that interest rates will remain low is also a big risk to the multi-year forecast. As we have discussed many times in previous market commentaries, the US government has been the beneficiary of the turmoil in Europe and elsewhere. The US government’s debt costs have decreased dramatically even as its deficits have soared to ridiculous heights. In our opinion, the CBO projections do not account for the possibility that holders of US debt rebel or find an alternative “reserve” currency. If this were to happen, budget projections could easily go off the charts.

I am sure that none of my exceptionally bright readers were fooled by the CBO’s latest projections. Despite what appears to be dramatic improvement, the budget situation remains a huge mess. The weak economy and turmoil in Europe are allowing our politicians to be complacent in their responsibilities to address the deficit problem. These latest figures from the CBO may simply exacerbate the complacency.