Renewed deficit hysteria based on flimsy CBO projection

It is often said that in Washington, no bad idea stays dead for long. This is certainly true for the crazy paranoia we see around the budget deficit and idea that it is going to bankrupt the country and leave our children impoverished. The moral of this story is usually that we need to cut and/or privatize Social Security and Medicare.

The deficit hawks had been relatively quiet the last few years. They had a big victory with the 2011 budget deal between President Barack Obama and House Republicans. This led to substantial reductions in spending for 2012 and subsequent years. These cuts slowed the economy and kept millions of people from getting jobs, but the small positive from the deal was that it temporarily silenced the deficit hawks. After all, with the deficit falling rapidly and the debt-to-GDP ratio going down, what did they have to complain about?

But the new budget projections released last month by the Congressional Budget Office (CBO) resurrected their complaints from the dead. The projections show deficits rising as a share of GDP with the debt-to-GDP also rising.

These projections were covered widely when they came out, but perhaps more importantly they became prime talking points for the deficit hawks. The clique of groups funded by hedge fund billionaire Peter Peterson responded to the new projections like a shot of adrenaline to the heart. They are now flooding newspapers with ads warning of the evils of runaway budget deficits. The Washington Post gave another round of stern warnings about irresponsible politicians. Needless to say, there will be much more in this vein. For this reason, it is worth taking a closer look at the CBO numbers.   

The numbers show the deficit rising from 2.9 percent of GDP this year to 4.9 percent by 2026, the last year in the projection period. While a deficit of 2.9 percent of GDP is small enough to leave the debt-to-GDP ratio pretty much constant (the economy would be growing at roughly the same pace as the debt), a deficit of 4.9 percent of GDP would mean the debt is growing more rapidly than the economy. If the CBO projections prove correct, we would be on path of rising debt and interest payments. That’s not by itself terrible, but it does imply that interest payments on the debt will be a growing burden on the economy over time.

However the CBO’s projection of a rising deficit is not based on a projection of either increased spending or lower taxes. Its sole basis, rather, is the CBO’s assumption that interest rates will rise sharply over the next few years. While the interest rate on 3-month Treasury bills is currently around 0.25 percent, CBO projects it will rise to 3.25 percent by 2019. The interest rate on 10-year Treasury notes is currently 1.8 percent; CBO projects it will be more than 4.0 percent by 2019. Based on these sharp increases in interest rates, CBO projects that net interest will increase by 2.0 percentage points of GDP over the next decade, fully accounting for the projected increase in the deficit.

While CBO may be right in its interest rate projections, it is important to realize that they have been projecting that interest rates will rise sharply for some time. In fact, their projections in each of the prior six years, from 2010 to 2015, showed that interest rates would rise sharply over the next 2-3 years. In each case, CBO’s projections proved wrong. Interest rates remained pretty much constant or actually fell, and are little different at the beginning of 2016 from what they were at the start of 2010.

It’s possible that 2016 will be the year that CBO finally gets it right, but it is also possible that it is again making dire deficit projections based on illusions about the way the economy works. If interest rates follow the same pattern they have over the last six years, rather than the path projected by CBO, there is nothing to worry about as far as exploding debts and deficits.

This episode offers important background for budget debates. When the deficit hawks start yelling about projections of out-of-control deficits, they are relying on projections that have repeatedly shown to be wrong in the past. That is a flimsy basis for their preferred path for deficit reduction: cuts to Social Security and Medicare.

In fact, rather than suffering from deficits that are too large, the economy’s major economic problem is deficits that are too small. As has been the case ever since the collapse of the housing bubble, we don’t have enough demand in the economy. The Fed has tried to boost private sector demand by lowering interest rates, but this has clearly proven insufficient.

There is no shortage of areas where additional public spending could both boost the economy in the short-term and meet important needs for the longer term. Infrastructure spending is the top of most people’s lists. Just think, we kept people out of work in order to avoid giving the children in Flint safe drinking water. Not only is this absolutely awful social policy, but it is also bad economics.

So don’t let the deficit hawks fool you. We need more spending and more demand in the economy today, and it is quite likely this will continue to be the case for some time into the future.