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For 50 years or so the federal government has deliberately and to an increasing extent misstated probable future budget deficits. Democrats and Republicans are guilty. The White House is guilty. And so is Congress. Private firms that deliberately misrepresent their financial statements in this fashion would be guilty of a crime… The magnitude of the misrepresentation is breathtaking.
– Former St. Louis Federal Reserve Bank President William Poole, writing in the Wall Street Journal last April
We’re guessing he was especially miffed with the annual budget outlook released by the CBO on February 5th.
Consider that Poole favored the “alternative scenario” that can sometimes be found deep within CBO reports and spreadsheets. This scenario corrects for at least a few of the absurd assumptions in the primary budget projections (the “baseline scenario”) that receive 99% of the media’s attention. Poole called the alternative scenario “the only truly honest and useful effort in town.”
Alas, the alternative scenario is no more – the CBO removed it from their annual outlook. Taxpayers can no longer find meaningful budget projections anywhere in the CBO’s work.
Let’s see if we can fill in the gap.
We’ll start with the baseline from this month’s report:
The chart shows a shrinking deficit over the next couple of years, but don’t get too excited. Apart from other issues we’ll discuss, this is explained by a long-standing prediction for a robust economic recovery, which hasn’t yet come to pass. It’s not so much a budget outlook as a hopeful forecast.
After the supposed economic boom levels off in 2018/19 (according to the assumptions), the figures no longer hide our deteriorating finances. But the deterioration is likely to be much worse than the chart suggests, as we’ll explain below. To create a more realistic outlook, we’ll adjust the baseline scenario for four different types of deficiencies in the CBO’s approach:
Step #1: We deal with dishonest lawmakers
One of the challenges in budget forecasting is that tax and spending laws are full of provisions that are all but guaranteed to be reversed before they take effect. These dead-on-arrival provisions only exist to create the appearance of fiscal rectitude. And the deception works because the CBO is required by governing statutes to build the phony provisions into its baseline, which the media then endorses as an authoritative view of public finances.
Fortunately, though, the CBO’s new report provides data we can use to neutralize some of the lawmakers’ tricks, as explained in Table 1 below:
Step #2: We get real with the economy
The good news in the CBO’s latest report is that they made a few needed changes to the underlying economic assumptions. The bad news is that they have much more to do – the economic outlook remains unrealistic.
Once again, though, we can use data in the report (Appendix E, in this case) to improve the projections. We explained our adjustments in detail in “Why Mr. Smith Has More Work To Do,” and they’re summarized in Table 2 below.
Note that we’ve accepted the CBO’s strongly optimistic outlook for the next four years, not because we like it but because it’s easier to show inconsistencies and come up with a more realistic scenario in later years (after the assumed recovery reaches historic extremes).
Step #3: We put on our actuarial hats
It doesn’t take much business experience to know that budget plans are regularly thrown off track by unexpected events, and the federal budget is no different. In fact, the CBO always acknowledges the risks of such setbacks. Yet, its governing statutes don’t permit accounting for most types of unexpected events in the baseline scenario.
In any case, the CBO doesn’t provide sensitivity analysis estimating their possible effects. Here’s what we had to say about this in an earlier post:
[M]any events are deemed too unpredictable to be estimated – an excuse that defies both collective knowledge and common practice. Actuaries, accountants and financial risk managers are all trained to place numeric estimates on unforeseen risks. Insurance premiums, credit loss provisions and investment decisions are all based on these numeric estimates.
The key is that any positive number is better than nothing. We can see the problem with nothing just by noticing that the debt debate almost never gets around to the risks of recessions, financial crises, wars, natural disasters, and so on. Political leaders and pundits habitually ignore the CBO’s warnings that these events will occur from time to time, relying instead on its incomplete projections.
In the same post, we explained our approach to adjusting budget projections for unforeseen events. One of our recommendations, which accounts for the effects ofautomatic stabilizers and doesn’t violate the CBO’s statutes, was implemented by the CBO for the first time in this month’s report. The other adjustments are summarized in Table 3 below:
Step #4: We recognize that debt owed to trust funds is, indeed, debt
The question of whether to look at gross debt (including obligations to trust funds such as the Social Security and Medicare hospital insurance funds) or net debt (excluding those obligations and other intra-governmental holdings) is a tired subject. It’s probably fair to say that net debt advocates don’t care much about debt to begin with, while those who point to gross debt do care. We offered our two cents here. Among other points, we described the paradox that fiscally profligate governments can lower net debt (but not gross debt) by merely expanding certain types of entitlement programs, even if the expansions are fiscally unsustainable. In fact, America’s current financial position shows that this is exactly what we’ve done. For this reason and others, trust fund debt should be added back to the net figures highlighted by the CBO.
Putting it all together
Note that the figures in the tables above exclude debt service costs. After breaking the baseline into components and making our adjustments, we then create new projections that include recalculation of debt service.
The Steps 1 and 3 adjustments are combined into a projection that we call “Congress does what it usually does,” while the Step 2 adjustment is blended into our “and the economy does what it usually does” projection. The Step 4 adjustment is shown in the “and trust fund debt counts” projection in the final chart.
Here are our results, for deficits first and then debt:
While the charts speak for themselves, we’ll turn again to Poole’s op-ed to sum up America’s finances:
U.S. fiscal policy is in a chaotic state. Policy decisions are wrapped around the convoluted budget accounting that Congress and the White House use to obfuscate, dissemble and hide what is really being done. That is a tragedy, and our democracy is worse for it.
(Click here for an appendix to this post containing the year-by-year added deficits for each of our adjustments, in dollars.)
Guest Post: Underneath Their Autocratic Rulers, Russia And U.S. On Diverging Societal Paths | Zero Hedge
Submitted by L. Todd Wood, a former special operations helicopter pilot and bond trader.
Underneath Their Autocratic Rulers, Russia and U.S. on Diverging Societal Paths
As the State of the Union address highlighted, both the Russia Federation and the United States have leaders that lean toward various degrees of autocratic government to achieve their agendas. President Putin rules with an iron fist and treats the legislative branch as an afterthought to use as needed but otherwise ignores. President Obama declares he will use executive action to get what he wants and quietly uses government agencies to intimidate and stifle his opposition in flagrant abuses of power. Putin has dismantled the Russian free press and imprisoned vocal opponents. The majority of the American press does Obama’s bidding for him while the administration puts movie makers in jail.
Underneath the tyrannical policies of the two Presidents, American and Russian society are diverging. First let’s look at welfare – it really doesn’t exist in Russia. If you’re a single mother raising your child alone, the state will pay you less than $50 a month. Unemployment insurance is also miniscule. The minimum wage is around $200 a month. I recently asked a Russian friend what they would receive if they lost their job. Her answer was, “It’s my problem, why should the government pay?” Health care is free but of very low quality. Russians with money typically choose private care and buy their own private health insurance.
In the United States, we are seeing an obscene explosion of the nanny-state. Obamacare has been exposed as a huge wealth redistribution scheme. The CBO states that the ACA is a disincentive to work. Disability payments are skyrocketing. The number of Americans receiving food stamps has doubled and is spiraling out of control. Welfare work requirements have been weakened. The left continuously pushes to add more immigrants to the government dole and refuses to enforce current immigration law.
The difference in the tax code between the two countries is also striking. If you live in New York, the combined government tax bite is above sixty percent. It is a safe bet that any Democratic state government will continue to try and raise taxes. Obama raised rates on the top earners in America and would boost them across the board if he could. In Russia, the individual tax rate is a flat thirteen percent. There is an eighteen percent VAT and the corporate rate is twenty-four percent. If Russia could remove her corrupt barriers to entry, her economy would explode higher.
The difference between the two nations when approaching geopolitical challenges cannot be more extreme. The United States has shown a willingness to abandon long standing allies time and time again on the global chessboard. Whether it be Israel, Poland, or Saudi Arabia, the Obama administration has shrank from global leadership and left a gigantic vacuum for President Putin to happily fill. Russia has shown a willingness to ignore Western political correctness and stand up for Russian long-term interests. One only has to look to the Iranian nuclear issue, the Syrian situation, or the Snowden embarrassment to see evidence of Putin schooling the American government. The American position seems to consist of avoiding conflict and appeasing adversaries rather than standing up for historical American values, our allies, and our way of life.
One of the most interesting differences that has been inconveniently obvious in the international press is the Russian refusal to embrace the religion of global warming. While the American government strives to shut down energy economic engines of power, Russia uses energy to achieve its national goals. Putin has been quoted as describing the climate change alarmist agenda as a marketing scheme. Putin has not bought into the madness of crowds to the benefit of Russia.
Perhaps the most curious cavern between the United States and Russia is their approach to religion. The church was effectively shut down during the Soviet experiment. However, in the last few decades, the Russian Orthodox Church has roared back to favor in Russian government opinion. President Putin has even felt emboldened enough to accuse the West of being morally decadent. The Democratic Party in the United States has largely morphed into an atheistic, anything goes, hedonist entity. One only has to look at the refusal of the Obama administration to enforce marijuana laws in America to find evidence of this fact.
I recently had a conversation with a young urban professional in Moscow. Their comment to me was that most young Russians were embarrassed of the communist revolution in Russia. “They killed our best people,” this person commented. I find it curious that the Rolling Stone recently published an article extolling the benefits of the teachings of Karl Marx and echoing the mindset of many of the current millennial generation in America. When the youth of American are yearning for communism, I fear America must relearn the very harsh lessons of the past. If Russia can ever deal with the specter of corruption, her society may leap to the future.
It’s easy to show that public institutions such as the Federal Reserve and Congressional Budget Office (CBO) are routinely blindsided by economic developments. You only need to compare their past predictions to real events to see these organizations’ deficiencies.
More importantly, we can demonstrate that their struggles are all but certain to continue. This may sound like a difficult task, but we’ll argue that it’s easier than you think. Using historical data and basic economic concepts, we’ll explain not only why the establishment view is wrong but that the underlying principles are fundamentally flawed. The implication is that existing policies are destined to fail.
To make our case, we’ll start with the CBO’s current forecasts for real per capita GDP (economic growth net of inflation and population growth):
Our regular readers already know that the CBO is abnormally bullish on near-term growth, based on its long-standing assumption that the gap between actual and potential output will swiftly close. But this won’t be our focus here. In fact, we’ll assume the CBO gets this part of its outlook right. We’ll be shocked if it does, but let’s pretend.
We’ll then examine the forecasted path for interest rates:
The interest rate outlook is an offshoot of the policy establishment’s overall approach. Monetary stimulus is expected to be removed as it guides the labor market toward full employment, allowing interest rates to return to normal levels. At that point, natural economic forces are believed to be strong enough to preserve a normal, healthy economy. Establishment economists have near complete faith that this is a sound and reliable process.
But closer examination reveals a few cracks. Consider that the chart above shows quite a jump in interest rates, which begs the question: How will the economy weather such a development?
We’ll look to history for possible answers. We calculated the change in rates on three month Treasury bills for every eight quarter period since 1953, which breaks down like this:
We then reviewed past economic outcomes conditioned on the rate buckets above. Note that the forecasted 2015 to 2017 rate change of 3.2% (the leap from 0.2% to 3.4% in Chart 2) falls in the final bucket. Therefore, this bucket is especially relevant to the economy’s likely performance in the next rate cycle. We circled it in the charts below:
While the results speak for themselves, I’d be remiss if I didn’t add qualifiers. For one, the sample sizes fall as you move from left to right across the charts. Moreover, history doesn’t always foretell the future; this time could be different.
But the thing is: the data makes perfect sense. Higher interest rates have obvious effects on risk taking and debt service costs. It stands to reason that the economy won’t just sail through the large rate hikes needed to restore historic norms.
If anything, the charts likely understate the future effects of rising rates, because today’s debt levels are far higher than average historic levels. Any normalization must also include a wind-down of unconventional measures such as quantitative easing, which presents additional challenges.
Yet, the official outlook calls for steady improvement both through and beyond the rate jump. As shown in Chart 1, the CBO predicts that per capita GDP growth will accelerate to over 3% before settling back to a trend rate of 1.2%. Forecasts for 2018 and 2019 average a healthy 1.5%, despite the figures in Chart 5 showing virtually no growth after large interest rate increases in the past.
Here’s the corresponding outlook for employment, followed by two more reasons to expect forecasts to fail:
In a word, the CBO’s projections are preposterous. They ignore effects that are clear in the data and obvious in real life. But the charts reveal more than just forecasting flaws at a single governmental institution. More broadly, the assumption of a smooth and lasting return to normality is standard practice for mainstream economists, particularly those at the Fed.
Essentially, economists are hardwired to focus on the near-term effects of policy stimulus, while overlooking long-term effects that are often far more important. Standard models fail to account for either natural cyclicality or the payback seen in Charts 4 to 6. Although establishment economists often speak about sustainable growth, they really mean anygrowth that restores GDP to where they believe it should be. They don’t seriously contemplate the unsustainable growth that occurs when the economy is over-stimulated through credit and financial asset channels. And the charts above demonstrate these deficiencies.
Worse still, this analysis doesn’t tell the whole story. We could have easily tripled the chart sequence with other indicators of Fed-fueled credit and asset market froth – from record margin debt to lax loan covenants to soaring public debt – that also show heightened risks of another bust.
We suggest giving some thought to the data shown above and considering its message for the future. Send it to the smartest people you know and get their opinions. In the meantime, here are our conclusions:
1: Even if the economy returns to full employment under existing policies, it won’t remain there after (and if) interest rates normalize.
2: Based on today’s debt and valuation levels (charts 8-9, for example), rising interest rates will have an even harsher effect than suggested by the 60 year history (charts 4-6).
3: Contrary to the establishment’s “sustainable recovery” narrative, the most plausible outcomes are: 1) interest rates normalize but this triggers another bust, or 2) interest rates remain abnormally low until we eventually experience the mother of all debt/currency crises.
Conclusion 3 restated: We’re stuck in an Escher economy (see below), thanks to the impossibility of the establishment economic view, and this will remain the case until the existing structure collapses and is rebuilt on stronger policy principles.