Last week, the White House released its annual Mid-Session Review of the budget (which I will call the MSR out of habit). It surprised most of the old budget hands in Washington – because it came without fanfare, it was actually early (the statutory due date is July 15), and for several years it has been delivered late (as was this year’s full budget). One element of the rollout that wasn’t much of a surprise was that the news surrounding the document sounded good. The story was that the deficit is down significantly from what had been expected, and that the outlook is for continued improvement. In fact, in just a couple of years, the annual deficit would decline sufficiently for the debt to begin to shrink, and to continue shrinking, relative to the size of the economy. At least, that was the spin on the document, that was what the press reported, and that was what most people heard.
As most of you would suspect, the superficial stories in the press put too much gloss on the true picture. Though we have been over this general territory before, the MSR is an important part of the annual budget process, and the interpretation of this year’s release could have significant influence on the public mood on this issue. So just to be sure, I’ll give you a rundown on some of the details. To summarize, the headlines focus solely on the very near term to the exclusion of the future (which is what the budget is really all about), and miss the subtleties of what the MSR and the Administration’s budget document really are. By the time we are done, you likely will take only the most limited comfort in the new information from the White House, and your concerns for the long run will be, if anything, a little greater.
To begin with, the projected deficit for fiscal year 2013 – the current fiscal year, which ends less than three months from now – is in fact down, by $214 billion (or 1.3 percent of GDP), from $973 billion to $759 billion. The nation’s debt still will grow faster than the GDP – up to 75.9 percent by year end – but we will carry a little less of it into fiscal 2014. This certainly beats the alternative, and I would not want to suggest the contrary.
Still, the headlines saying “deficit down” relate only to fiscal year 2013. If you look at each year’s changes in the Administration’s estimate of the bottom line of its budget, you find that the current year’s number is the only one that improves. The deficit for every year in the following ten-year budget window increases – by $6 billion, or 0.1 percent of GDP, in 2014, rising to $109 billion, or 0.4 percent of GDP, in 2023. These changes by themselves are not catastrophic, and you can be assured that they will be revised further twice per year over the next ten years. But they do not by any stretch suggest that the budget outlook is improved.
It pretty much goes without saying that the modestly worsening future-year budget outlook cannot be good news. But the sources of the changes in the outlook are a bit unsettling in and of themselves. The largest single source of improvement – almost exactly one-third of the total – is a payment to the Treasury from Fannie Mae and Freddie Mac. There is no prospect of that payment being repeated in future years; in fact, the budget’s estimate is for about one-half of it to flow the other way, back out of the Treasury, over the next ten years. Most of this year’s payment is described as “a $50.6 billion increase in the valuation of Fannie Mae’s deferred tax asset,” which is not exactly inspiring verbiage.
The second largest source of this one-year improvement is $65 billion in increased tax revenue. Again, this beats the alternative. But the tendency in the popular press to describe this improvement as due to “the strengthening economy” turns out to be precisely wrong. In fact, incomes in the economy have grown less than anticipated; what has increased is the amount of revenue that the government has collected per dollar of GDP – even though the amount of GDP is less than anticipated.
One typical reason why this would occur is a greater volume of realizations of capital gains – which do not constitute economic output, are the result of a past run-up of asset values, and are unlikely to repeat themselves. Think of it this way: Asset values, primarily in the stock market, are equal to some multiple of earnings, which in turn are limited by the amount of the GDP. And there is a “stock” of unrealized asset appreciation out there in the hands of investors. We have had a jump in the amount of realizations of capital gains, but that means that the stock of unrealized gains is correspondingly depleted. The new owners start out, of course, with precisely zero accrued but unrealized gains. So unless we have a spurt of economic growth to increase earnings, and in turn to increase asset values – or unless the markets are so confident as to run up multiples indefinitely – therefore, it is unlikely that asset values will continue to spiral upward.
Another possible contributor to this upward technical reestimate of revenues is a greater-than-anticipated concentration of ordinary income in the hands of persons in the highest tax rate brackets. That, again, can go only so far. It certainly is less portentous of future revenue improvement than would be robust and widely enjoyed income growth. Again, we should be happy to have the greater revenue, and therefore the lesser debt; but these developments do not increase the prospects of budget – or economic – improvement in later years.
The third largest source of improvement in the 2013 budget is reduced discretionary spending – spending out of annual appropriations by the various federal agencies. The reason for this improvement is simply that the Administration proposed, and expected, that the spending “sequester” would be avoided. Now, more than nine months into the fiscal year, the sequester clearly is a fact of life. (Still, incidentally, the Administration continues to propose that the sequester be repealed.)
Take those three sources of improvement in the 2013 budget, add the reduced debt service resulting from them, and you have 85 percent of the total reduction in the projected deficit. Everything else is an amalgam of small puts and takes, with virtually no indication of likely future improvement in the budget picture. So to repeat, it’s fine to have a lower deficit this year, but that bears no indication of further good news to come.
In fact, if anything, the outlook is to the contrary. The economic forecast has not been revised by much, but to the extent that it has, it is slightly worse: a postponed recovery, lower levels of GDP and employment, and so on. Therefore, following from the slightly weaker-than-expected economy, the small mandatory (“entitlement”) outlay reestimates, like the revenue revisions, are if anything worsened by the economic picture. There are some favorable technical and economic reestimates – fewer than expected people showed up to apply for Social Security benefits, and slower inflation resulted in smaller cost-of-living benefit increases – but generally, lower economic growth has meant lower wages and more people eligible for, as an example, the Supplemental Nutrition Assistance Program (or SNAP, formerly known as Food Stamps).
The new budget reestimates and the underlying economic forecast revisions should not be taken as a death sentence. Circumstances will change, and the economic forecast will be wrong, and could prove pessimistic. I just want to make clear that the optimistic headlines in the popular press do not reflect even the first layer of detail in the MSR.
So one dimension of the budget story – that the outlook is better because of an improving economy – turns out to be far overstated, if not outright wrong. The economy is worse than was anticipated, which is to say that it is recovering less rapidly than had been forecast. The budget will be better for this one year, because of what appear to be largely one-time events. The outlook is darker than had been hoped.
The second dimension of the Administration’s story – that the budget outlook includes falling deficits, and a debt burden that will shrink relative to the size of the economy – turns out to be true only in the limited sense that it is a “budget” – that is, a book – released by a President. It needs to be understood in a broader perspective, where its significance is much less.
The popular press routinely compares budget projections from the White House Office of Management and Budget (OMB) and the Congressional Budget Office (CBO). However, those projections are two fundamentally different things. CBO, by law, presents a “baseline” – that is, where the budget will go if the Congress clicks on the autopilot and leaves it on for 10 years. That is an admittedly slippery concept – the Congress will need to pass appropriations bills every year, and it won’t leave the rest of the law alone, either. (There are expiring tax cuts and triggering automatic spending cuts that the Congress might want to change. And there might be a hurricane or two, and maybe even a forest fire.) But at least the baseline is a neutral concept.
A President’s budget (with its Mid-Session Review) is totally different. It assumes that the President’s program is enacted without change. That is, of course, the general equivalent of assuming that pigs will fly – especially these days. Now, you shouldn’t demonize the President’s budget, any more than you should canonize CBO’s baseline. Nor should you attack the people at OMB who generate the document; they are following the law, after all, and are rightfully doing what their boss, the President, tells them to do. The President has to tell you what the effect of his program would be; if he doesn’t, who will? And he has to do so from his perspective, because others will be more than happy to put their contrary spin on the President’s proposals.
But you need to understand the President’s budget projections for what they are, and that is especially important right now. Because with respect to the debt, the difference between the baseline and the President’s projections is the difference between up and down.
The President’s Mid-Session Review does provide a baseline, but it is not the headline number. Furthermore, in recent years, Presidents have tended to adhere to the legal definition of the baseline much less strictly than does CBO. (Adherence to the law gives CBO political protection from those who might want to see more or less favorable numbers; it always helps to be able to say, “The U.S. Code made me do it.” In contrast, any President’s political opposition will complain about anything he does, so he might as well choose to show the numbers as he wishes them to be perceived.) In this Mid-Session Review, and under the assumption that the President’s program is enacted into law, the budget deficit does fall below the magic 3 percent of GDP threshold, below which (at current assumed rates of interest, real economic growth and inflation) the public debt falls as a percentage of the GDP. That was the White House’s headline story: We have found the promised land, and the nation’s finances have achieved sustainability. Footnote: If you enact the President’s budget program.
However, under the White House’s own “adjusted” budget baseline – the closest representation that they provide of what would happen if legislative stalemate were to continue – the budget deficit is in the comfort zone only in 2017 and 2018. Before and after that brief interval, the debt grows faster than the GDP – that is, the debt-to-GDP ratio rises – and so the nation continues its march toward a fiscal and financial day of reckoning.
And again, in terms of which way the numbers have moved, the new estimates of the deficit with the President’s policy in place are higher in every year except for 2013. Because of changes in the underlying law – recalibration of the figurative autopilot – there is no consistent measure of the Administration’s baseline between the beginning or this year and the MSR. However, there is little doubt that such a consistent baseline would have worsened, too.
As to which way the numbers will move in the near future – in other words, what are the “risks to the outlook” – there are two more-specific questions we need to consider.
What is the likelihood that the President’s program – or anything like it – will be enacted? Washington is in total gridlock. The Senate just spent days over whether it would choose to incinerate itself through the so-called “nuclear option.” The House has rejected even considering the Senate’s immigration bill – which some had considered the greatest prospect of achieving some measure of bipartisan cooperation, and to do so in the House majority’s own political interest. The House also has passed a farm bill that is totally partisan – whereas for years this vehicle was the glue that brought and held together urban and rural legislators. As fundamental as it is to our policymaking system, this farm bill will never achieve enactment in the Senate. The atmosphere could not be worse.
But the substance is. Democrats insist on a revenue increase; Republicans insist on none. Republicans insist on structural change in Medicare; Democrats insist on no change at all. My long-time Washington friends have never seen the machinery of government so frozen.
Yes, there are bipartisan conversations underway on tax reform. In some respects, and on the surface, the processes in the House and the Senate look admirable. I have been invited to speak to bipartisan staff sessions for both the House Ways & Means and the Senate Finance Committees (the Senate session just this week), which were well attended. The House staff working group had two Member co-chairs, one from each party, and both attended and actively participated in the conversations. However, in both chambers, the two political parties had to agree to disagree over the minor issue of the amount of revenue to raise to enable their processes to move forward. That can work for the purposes of informal discussions. It will not work for enacting legislation. One scenario that is sometimes discussed is that the two parties would agree to pass a revenue-neutral tax reform bill as a first step toward addressing the budget, and then proceed to the rest of the task. But it is hard to imagine Democrats taking the heat for offending their supporters who would be adversely affected by such a revenue-neutral tax reform, without any guarantee that they would get some additional revenue in return. Even House Republicans would fear that a bill that they found acceptable would die in the Senate, after they crossed their constituencies who benefit from the tax preferences that were putatively repealed in the process.
There are also some who remain optimistic about the “action-forcing events” of reaching the statutory debt limit, expected perhaps in November, and the expiration of the annual agency appropriations at the end of September. Outcomes could change, but similar events over the last few years have ended in tears, not progress.
Let’s dissect the political dynamic just a bit. With all of the massive unspecified future savings in annual agency appropriations now assumed in the law and the baseline, the Congress has played all of the easy cards in this game, plus some that aren’t even in the deck. (The economist in the old joke about the three academic desert-island castaways who assume the existence of a can opener had nothing on the legislators who made that August, 2011 budget plan.) The remaining choices are all much harder, and much more evident and real. With no sense of bipartisan cooperation, and the air of complacency arising from the MSR and the few other small shards of good news, it is hard to imagine the two parties biting the bullet and doing something substantive.
So what happens at the end of this year, when the appropriations expire and the debt rises all the way up to hit the bell at the county fair? There is no obvious answer, no two negotiating positions between which you can just split the difference. The budget geeks with whom I hang out are all stumped; this is the first time in my memory when you haven’t gotten two more opinions than the number of economists you had in the room.
Here is the scenario that floats to the top when I am in an optimistic mood: The appropriations decision is postponed to the end of the year (through a continuing resolution, or “CR”), when the debt limit hits and all of the other triggers (tax extenders, automatic Medicare cuts, etc.) are set to be pulled. At that point, those in the Congress who would push the Treasury over the debt-limit brink are overruled by their more prudent colleagues – if only because the latter fear the political consequences of even the threat of a financial meltdown, after the public fiasco of August, 2011. Agreeing on nothing, the two sides pass a bowl full of mush, and put the problem off until next year. In the meantime, the United States of America lives off of its reputation just a little bit longer, and depreciates that reputation a little bit more in the process. I hope that I am wrong – but frankly, given the other alternatives visible on the table, I would take that one in a heartbeat.
Is the economy likely to live up to the Administration’s economic forecast? Let’s ask just one more question: Is the consensus economic forecast – slowly building growth, no recession, low inflation – likely to hold? Are the growth risks to the upside or the downside?
Without being numerically specific, I just think about the conditions surrounding our economy: weakness in Europe, weakness in China, weakness in Japan, weakness in several developing economies, remaining substantial housing inventory hidden in the cloak of foreclosure and covered by a still marginally functioning housing finance system. And then, of course, there is the uncertainty surrounding government’s fiscal imbalances.
In this environment, I just don’t see any pricing power, and so I just don’t see any inflation. Reinforcing this point, given all of the negative contingencies for the economy, any growth surprise is going to be to the downside. You may have seen the “Back In the Black Blog” posts over the last two weeks that highlighted the Federal Reserve’s modulation of its talk after its last meeting about tapering of financial asset purchases under quantitative easing. Well, that modulation continues, following after the continuing softening in the economic numbers ever since that initial talk of the end of QE-II.
This continues to leave fiscal policy in a box of Catch-22s. The weak economy continues to make sudden and substantial debt reduction hazardous. Meanwhile, the steadily mounting debt becomes an ever-more-serious hazard.
That’s the good news for this week. Enjoy the heat, and stay tuned for even more happy talk.