The not-so-incredible shrinking deficit

Aug 16th 2005
From The Economist Global Agenda

A new forecast from the Congressional Budget Office shows America’s budget deficit once again coming in lower than expected. Republicans, unsurprisingly, are rushing to claim credit for sound economic management. But the long-term outlook is still soaked in red ink

GEORGE BUSH has the dubious distinction of presiding over the largest negative budget swing in American history: from a surplus of $236 billion in 2000, the year he was elected, to a deficit of $412 billion, or 3.6% of GDP, when he stood again in 2004. Even in an economy with output of around $12 trillion, $648 billion is a lot of money to misplace.

Analysts were aghast when the Bush administration’s Office of Management and Budget (OMB) projected that the fiscal year to September 2005 would bring bigger deficits still: $427 billion, according to numbers released in February. The more cynical observers suggested that the administration was simply releasing a gargantuan number for the pleasure of later telling voters that the budget deficit was closing faster than expected. In support of their argument, figures released by the Congressional Budget Office (CBO) in March projected a deficit of only $365 billion.

When the OMB revised its numbers sharply downward in July, to $333 billion, the doubting Thomases seemed to have a good case. Now, however, the CBO, which is generally seen as more level-headed, has followed suit. In its Budget and Economic Outlook, released on Monday August 15th, the CBO’s projections moved roughly into line with the administration’s, forecasting a shortfall of $331 billion, or roughly 2.7% of GDP.

Republicans, unsurprisingly, rushed to claim credit for the improvement. Tom DeLay, the majority leader of the House of Representatives, said that the brighter budget picture “should come as no surprise” to anyone familiar with the Republican platform of cutting taxes to spur economic growth. Many voters are also prepared to give Mr Bush the benefit of the doubt. The economy, after all, seems to be chugging along nicely. Real GDP grew at a solid 3.4% in the second quarter of 2005, an annual rate envied by most European countries. Even America’s budget deficit doesn’t look so bad when compared with the likes of Italy and Germany.

Democrats, of course, pooh-pooed the notion that a mere third of a trillion dollars-worth of new debt was anything to smile about. More significantly, Douglas Holtz-Eakin, the CBO’s director, gave a warning that the improvement, while welcome, seemed to be largely temporary. The CBO’s report attributes most of the decrease to an unexpected surge in corporate income tax receipts, thanks to double-digit growth in corporate profits since the end of the 2001 slowdown. But the boom in profits cannot be sustained over the long term, especially since much of the increase seems to stem from short-lived changes to the tax code.

Further out into the forecast period, the CBO says its outlook is largely unchanged. The deficit will shrink slowly until 2010, then drop sharply as Mr Bush’s tax cuts expire. Federal debt will tick slightly upward, reaching almost 40% of GDP by 2010, and then begin declining as the expiring tax cuts push the budget back towards balance.

The cloudy crystal ball

All of this is, of course, more art than science. The CBO itself notes that even if there are no legislative changes in levels of taxation or spending, the vagaries of economic forecasting mean that there is a 25% chance that the budget will be in balance, or show a surplus, in 2010—and a 10% chance that that year will see a budget deficit greater than 5.9% of GDP. And many of the assumptions that the CBO makes, or is forced to make, seem rather far-fetched. It assumes that discretionary spending grows only at the rate of inflation, for instance, even though in the recent years this category has grown at multiples of the inflation rate. It is also required to proceed as if all of Mr Bush’s tax cuts were destined to expire on schedule, when in fact there is considerable interest in making them permanent.

But there’s one prediction it is making with a high degree of confidence: Social Security and Medicare, America’s old-age programmes, will eat up an increasing share of federal spending and thus spell big trouble for the budget. The first “baby boomers” will be eligible for early retirement in 2008. The strain of caring for the swelling ranks of America’s aged will begin to tell then, and it will get steadily worse throughout the remainder of the forecast period, which ends in 2015. The CBO thinks that Social Security, Medicare and Medicaid, America’s health-care programme for the poor, will together account for more than half of federal spending by 2015.

The CBO’s forecasting period does not stretch far enough to cover the biggest shocks to come. It is not until 2017 that Social Security’s outflows will begin to exceed its inflows, forcing the government to tap general tax revenues to pay benefits. Excess Social Security contributions have been masking a large portion of the budget deficit for years; without those “off-budget” surpluses, Bill Clinton would have struggled to close the deficit in his last two years in office, and last year’s shortfall would have been well over half a trillion dollars.

Mr Bush, of course, would argue that this is precisely why the country needs his proposed (and floundering) reform of Social Security. His opponents retort that it calls for a thorough repeal of his changes to the tax code. With 2017 comfortably distant-sounding, neither seems particularly likely. Instead, America’s government is bringing back the 30-year bond, which it retired in 2001 when surpluses seemed to stretch out as far as the eye could see.

As they run up the national charge account, legislators can at least take comfort that the latest round of downward revisions to forecasts seems to cast further doubt on the “twin-deficit hypothesis”, which argues that Mr Bush’s spendthrift ways are driving up the current-account deficit and putting the country in danger of a catastrophic revaluation of the dollar. Trade deficits have continued to soar even as budget deficits have come down, which tends to support a theory advanced by Ben Bernanke, the chairman of Mr Bush’s Council of Economic Advisers. He has suggested that a global savings glut is flooding America with cheap money, and that the government deficits may in large part have been mopping up surplus capital that would otherwise have been borrowed by America’s already debt-ridden consumers.

But even Mr Bernanke has stressed that deficit-reduction should still be a priority. “Not catastrophic” seems a poor guideline for fiscal policy, government or personal. For now, however, it appears to suit America’s politicians and consumers just fine.

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