Analysis published Tuesday by Barclays Capital argues that it won’t. This is due to the overly optimistic growth assumptions underpinning the CBO’s new deficit projections. Douglas Elmendorf, the CBO director, writes on the CBO blog that its analysis was performed relative to CBO’s March 2011 baseline.
Table 1.5 on page 14 details the baseline projections but the key point, according to BarCap, is that in March the CBO assumed 3.1 per cent GDP growth in 2011. For what it’s worth, BarCap, along with other forecasters, has since downgraded 2011 growth to 1.5 per cent. (It also projects 0.1 per cent less 2012 growth than the CBO.) Given recent results, this seems fair.
The OMB uses a model that translates a 1 per cent reduction in GDP growth into an extra $100bn budget deficit, at least according to comments made in January by Austen Goolsbee, former chairman of the Council of Economic Advisers. Therefore if you assume 2011 growth will be 1.5% rather than 3.1%, the debt ceiling deal only reduces deficits by about a half of what has been widely reported. Shrinkage!
Here are three charts from BarCap that depict the story:
Thus subpar growth in 2011 could wipe out any deficit reduction from the first round of savings from the debt ceiling deal. (And we haven’t even mentioned what would happen if interest rates were to rise.)
Some caveats. Forecasts are often inaccurate and optimistic. Traditional macroeconomic models would point to some form of “catch-up” growth in later years if 2011 continues to disappoint. And we don’t have a handle on whether the OMB’s sensitivity rule of thumb is a good one.
That said, BarCap’s back of the envelope analysis shows that all the discussions about the US fiscal situation are premised — somewhere — on the basis of a swift return to a trend growth rate. But we’re told by economists that this is unlikely in a balance sheet recession and/or following a financial crisis.
We foresee a possible problem ahead. And not just because the US’s short-term priority should be growth and jobs. If deficits aren’t reduced by their projected amount, this will be red meat for those calling for further cuts. But if growth remains stagnant, this is red meat for those calling for further stimulus. And thus the circular economic argument dominating American politics continues for the next two years, and beyond. This is a bind.
And to think, the debt ceiling deal isn’t even law yet.