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In the Nation's Interest

The Economy Is Almost Fully Recovered, but the Federal Budget Is Far From Cured

Last week the CBO budget and economic outlook showed that current budget deficits are down to what are considered economically sustainable levels: less than 3 percent of GDP. In this range the economy might be able to keep pace with the growth in debt.  As explained in President Obama’s Budget, just released (emphasis added):

Through these policies, the President’s Budget brings annual deficits well below the 40-year historical average of 3.2 percent of GDP during every year of the budget window.  A key test of fiscal sustainability is   The whether debt is stable or declining as a share of the economy… Budget meets that test, showing that investments in growth and opportunity are compatible with also putting the Nation’s finances on a strong and sustainable path.

But careful now:  that’s not as low a hurdle as it sounds. 

For one thing, the sustainability constraint is frequently misinterpreted as saying the economy needs to grow at the same percentage as deficits are a percentage of GDP, but in fact, the economy must grow at least at the rate of (deficit/GDP) divided by (debt/GDP) to keep up with debt growth.  So CBO’s estimated FY 2015 deficit of 2.6 percent is “sustainable” only if the economy grows by more than 3.5 percent (not 2.6 percent).1

For another thing, “sustainability” implies a sustained ability (ah!) of the economy to keep pace with the debt.  Deficits are much lower now than their historic highs in the depths of the Great Recession (in the 8-10 percent of GDP range).  But that’s because the economy has been in a recovery. This brings down deficits because: (i) the “automatic stabilizers” ease up (income and tax revenues rise, while spending on income-support programs like unemployment benefits falls) and (ii) spending designed specifically to stimulate the economy ends.  Now that the economy is almost fully recovered, we can’t expect deficits to keep shrinking due to these factors.  In fact, the CBO report agrees with this more pessimistic view.  Looking over just the ten-year budget window, the CBO report projects deficits to rise from below 3 percent of GDP over the next four years, to 4 percent of GDP in 2025.

Now that we are almost “back to normal” in the economy, we no longer have either the unusually large excuse for automatically large deficits, nor the unusually large justification for continued, deficit-financed “countercyclical” policies.  Unfortunately, getting back to the “same old, same old” economic and fiscal challenges is not good news, because we have come out on the other side of the Great Recession no better situated to handle our longer-term outlook of deficits and debt than we were when we entered.

To remind everyone what’s been our longer-term fiscal challenge for a very long time:

• Federal spending is growing rapidly as a share of the economy, largely through growing spending in the mandatory retirement-age benefit programs (Social Security, Medicare, and Medicaid). This is due to: (i) the aging of the population; and (ii) rising per-capita health costs.
• Meanwhile, federal revenues as a share of the economy have remained fairly flat.

These longer-term trends explain why even within the ten-year budget window we see federal spending start to veer upward, further away from revenues—and deficits rise from what starts out qualifying as economically “sustainable” to what ends up not.

And even the ten-year baseline budget story—which turns into the “same old, same old” unsustainable story by the end of the ten years—is unrealistically optimistic.

The baseline reflects current law—what’s already supposedly “baked into the cake.”  Included in the current-law mix is the spending restraint that was imposed by the Budget Control Act, first through discretionary spending caps and then through a triggered “sequester” which applies to both discretionary and mandatory spending.

President Obama has already made clear that he doesn’t like the “mindless” spending restraints imposed by the Budget Control Act and that he would replace it with specific types of spending designed to invest in the economy, along with suggested ways of offsetting the added costs.  As the President’s FY2016 Budget explains (from the “fact sheet,” emphasis added):

Returning to the mindless austerity of sequestration in 2016 would bring discretionary funding to its lowest level, adjusted for inflation, since 2006. The Budget proposes to end sequestration, fully reversing it for domestic priorities in 2016, matched by equal dollar increases for defense funding.  These investments are more than paid for with smart spending cuts, program integrity measures, and commonsense loophole closers – including, for example, targeted reforms to crop insurance programs; program integrity investments across a range of programs; and closing the “carried interest” tax loophole.

Now, rejecting the “mindless” automatic spending cuts of the Budget Control Act would be perfectly reasonable if President Obama were being more “mindful” of the specifics of his alternative vision of deficit reduction, one with more revenue increases and fewer spending cuts.  Unfortunately, although the “middle class economics” agenda he presented in his State of the Union talked about some of his ideas for revenue raisers (mostly focused on the “rich”), the Administration has already started back-tracking on any deficit-reducing proposals, saying, for example, “never mind” about their proposal to cut the section 529 tax-preferred college saving plans.  Why?  Because his own party couldn’t stomach reducing such a tax subsidy, even one that primarily benefits upper-income households but does nothing to improve the access of lower-income students to a college education.

We will see more of this, and we have seen it many times before.  From our current-law baseline that looks improved, even if unsustainable, policymakers on both sides of the aisle and both ends of Pennsylvania Avenue will argue to take out any specific deficit-reducing elements, even as they put in new and specific deficit-increasing proposals.  Tax increases and spending cuts aren’t popular.  Tax cuts and spending increases are.  Those unpopular offsets are first talked about in vague terms that make them sound appealing to the public (“smart,” “commonsense,” and just closing “loopholes”); but when the more specific proposals are laid out to policymakers, they are resoundingly rejected.  So any bipartisan agreement (“compromise”) results in the policies both parties can agree on:  the tax cuts and spending increases, not what pays for them.  And deficits increase.  Meanwhile, deficits don’t seem to matter, because deficits are hard to understand.

But deficits do matter because they drain our economy’s ability to grow our productive capacity.  Now that we have almost fully recovered from the Great Recession, we have to get back to thinking about growing the supply side of the economy to ensure its longer-term strength.  That means increasing the quantity and quality of both our human and physical capital.  The problem with deficits is that they claim dollars from the rest of the economy.  And as the debt’s size relative to the economy rises, the more the productive contributions of both the public sector and the private sector to the economy are squeezed out.  And that means that the “goodies” (in the form of benefits handed out through tax and spending programs) that current generations demand come at the price of our future economy: the one our kids and grandkids will rely on to support their own well-being as well as pay down the debts that we parents and grandparents racked up.

And if that weren’t depressing enough, last week’s GDP report from the Department of Commerce’s Bureau of Economic Analysis showed a disappointing 2.6 percent annualized growth rate in real GDP in the 4th quarter of 2014—far lower than the expectations and hopes of over 3 percent. The “new normal” of the U.S. economy post-Great Recession might not turn out as strong as we need it to be.

So the economy might be almost fully recovered, but the federal budget is far from “cured.”  We have made disappointingly little progress since before the Great Recession, and now, it seems that policymakers are poised to continue to let us down.  At the same time there are huge questions about whether the “recovered” economy of today and the future will be strong enough to support the growing burden of government debt. Will there be any of the nation’s paltry savings left over to devote to growing the economy itself—through either private-sector or public-sector investments? Even if we manage to “hang in there,” it sure would be nice to say we have an economy that is reaching its fullest potential with the support of good fiscal policies, rather than merely surviving despite bad ones.


1. The FY 2015 CBO-estimated deficit as a percentage of GDP = 2.6 percent.  Current debt as a percentage of GDP = 74.2 percent. 2.6 percent divided by 74.2 percent = 3.5 percent or higher annual economic growth rate required to stabilize or decrease the debt to GDP ratio.

Diane Lim is Vice President for Economic Research at the Committee for Economic Development.