The Budget Morass

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by: Lance Brofman

Summary

The entire Federal Budget Deficit is now structural, since with 3.7% unemployment there is no cyclical component of the deficit.

Even without any recession, the Federal Budget Deficit will exceed $2 trillion within a decade, when reasonable assumptions are made regarding outlays and tax law.

Any recession will cause the deficit to increase even more than $2 trillion.

Interest on treasury debt held by the public will exceed spending on national defense.

There are two components of the federal budget deficit, namely the structural deficit and the cyclical deficit. The structural deficit is the level at a theoretical fully employed economy, otherwise defined as the natural rate of unemployment. The cyclical deficit arises when the economy is operating at less than full employment. Theoretically, the cyclical deficit becomes a surplus when the economy is at full employment. For any period, the actual deficit is the sum of the structural and cyclical deficits.

The cyclical component results from automatic stabilizers that reduce revenue and increase spending when unemployment increases. Tax revenue declines and spending on social safety net programs automatically increase during such periods pursuant to existing statutes as more people qualify for benefits.

The traditional method of disaggregating federal budget deficits into their structural and cyclical components is to estimate the size of the automatic stabilizers. From Table I attached, for example, in 2010 the federal deficit was 8.3% of GDP. The Congressional Budget Office (CBO) estimated the unemployment gap at 4.7% in that year, the gap being the difference between the actual jobless rate and the theoretical natural rate.

Based on this 4.7% gap CBO estimated the automatic stabilizers increased the actual deficit by 1.7% of GDP. So according to CBO, the structural deficit at the time was 6.4% of GDP and the cyclical deficit was 1.9% of GDP. The estimated deficit without automatic stabilizers exhibits movements which appear correlated to the business cycle.

The estimated deficit without automatic stabilizers would increase during times of recession and the existence of stabilizers accentuates the magnitude. The logical tendency to enact tax cuts and spending increases during recessions shifts the measurement of the total deficit so that more of it appears as structural. This means that were a recession to occur, the increase in the deficit would likely be larger than what would be the result of simply adding the structural deficit to the automatic stabilizers that were calculated based on current law.

Another related factor is that some outlays which are not considered cyclical have exhibited some cyclical behavior. In our Disability analysis dated March 18, 2018, we noted that labor force participation has a cyclical component, tending to fall during recessions and rising in recovery. But in this business cycle expansion, the participation rate continued falling in the recovery phase. One precipitating factor may have been the failure of Congress to extend jobless benefits at the end of 2013.

In our April 2018 report titled "Reality Check on the Budget Outlook," we highlighted a number of structural and cyclical characteristics of the CBO's ten-year budget outlook. This was the first and so far the only CBO analysis that incorporated the 2017 Tax Act and a $1.6 trillion spending agreement that was signed into law by the President.

The CBO outlook showed the deficit exceeding $1 trillion by 2020 and reaching $1.5 trillion by 2028. This projection was based on current law assumptions which assumed that personal tax cuts would expire in 2025 and that discretionary spending would be constrained by a reimposition of sequestration guidelines. We also pointed out that the CBO analysis did not allow for a cyclical recession or extraordinary external shocks like hurricanes or wars, for example.

In a scenario that we considered more realistic, we incorporated the likelihood that personal tax cuts would be permanent and that spending would rise in line with inflation. Given these, the deficit shows up as being much larger than the CBO baseline $1.5 trillion estimate. Even assuming an extension of the business cycle expansion to the end of the forecast period, this relaxation of assumptions would push the theoretical deficit to about $2.2 trillion and it would push the debt to about 109% of GDP.

We attempt to quantify the extent to which the magnitude of automatic stabilizers as calculated by the CBO underestimates the likely impact on the federal deficit that would accompany a significant increase in unemployment. One method is to calculate the ratio of the amount of the automatic stabilizers (the cyclical deficit) as a percent of potential GDP to the unemployment gap.

Table I attached shows as a percent of potential GDP the actual deficit and automatic stabilizers. It also shows what the deficit would be without the impact of the automatic stabilizers. It also shows what revenue and outlays would have been without the impact of the stabilizers. And it shows the unemployment gap and the automatic stabilizers - unemployment gap ratio.

As shown in Chart I, during the period of the largest unemployment gaps - i.e., 2009-2012 when the average gap was 3.9% - the average of the automatic stabilizers/unemployment gap ratio was negative .409 (.409). This means that an increase in the unemployment gap of 1% should increase the automatic stabilizers (cyclical deficit) by about 0.4% of potential GDP. So for example, the unemployment gap was 4% in 2011 and the automatic stabilizers were 1.6% of potential GDP. The actual deficit was $1.3 trillion in 2011, and the automatic stabilizers amounted to $254 billion. Hence, without the impact of the stabilizers, the 2011 deficit would have been $1.045 trillion. However, the amount of the stabilizers in 2011 does not include the extent that stimulus legislation reduced tax revenue and increased outlays. This underestimates the cyclicality of the deficit.

Our projection and the CBO projection are for deficits to reach $2 trillion by 2028 once politically realistic assumptions are employed that adjust the current law baseline. Thus, the $2 trillion deficit projection is only a projection of the structural deficit. In a recession, the true impact on the deficit is not only the automatic stabilizers but also the political deficit that should be considered as distinct from either the automatic stabilizers or the current law structural deficit.

The political deficit could be thought of as the government stimulus or extra relief spending, not contemplated in current law, but that is likely to occur in response to an increase in unemployment. In the event of an economic downturn, the true cyclical deficit would be in addition to the structural deficit. For example, if a downturn were to bring the unemployment gap to the 4.7% of 2010, the actual cyclical addition to the deficit would probably exceed the 1.9% of GDP estimated for 2010. Comparing the average stabilizer-jobless gap ratio during 2009-2012 of (0.409) to the average for the entire period since 1980, which was (0.591) suggests that the "true" cyclical impact on the deficit is about 50% larger during severe downturns. Using the average stabilizer-jobless gap ratio average for the entire period since 2002, which was (0.683), the true cyclical impact on the deficit is about 70% larger during severe economic downturns.

The Trump administration has largely ignored the federal deficit so far. Neither the Office of Management and Budget (OMB) nor the CBO adhered to the custom of publishing mid-year budget updates and forecasts. Indeed, the administration's underlying assumption remains that tax cuts will pay for itself over time by first leveling the structural deficit and ultimately reducing it if not absolutely then at least relative to GDP. One year into this experiment economic growth accelerated from 2% to 3% but revenue has been flat while spending has increased. Without the roadmap that OMB and CBO analyses provide, it is impossible to know how actual budget numbers compare with the expectation.

One problem that is daunting is that absent progress on deficit reduction, debt issuance is rising. In fiscal 2019, the treasury is set to issue nearly $1.34 trillion of debt versus "only" $546 billion in 2017. The amount is not far from the record $1.59 trillion that was issued at the depth of the financial crisis in 2010. As issuance soars, so too does the interest burden. Chart II attached in fact shows that under existing law, interest payments on the debt will exceed the defense budget starting around 2024.

The problem is even more acute because the current jobless rate of 3.7% is a full percentage point below what CBO had identified as the natural rate. If valid the cyclical budget would be in surplus as it would be even if the natural rate were at 4%. Our own bias is more aggressive in thinking that the natural rate is around 3%, which if valid suggests further room for declines in spending on automatic stabilizers and for non-inflationary growth to generate new revenue. This would imply a larger full employment surplus or concomitantly a smaller cyclical deficit, but not yet nearly enough to offset the spiraling structural deficit.

It is easy to imagine how the deficit would get out of control were there to be a turn in the business cycle or a spike in the interest rate structure. This is justification for the administration's recent attempt to jawbone the Federal Reserve toward steady accommodation. But it is not a remedy for policies that would make progress in reducing the structural deficit. In fact, virtually all proposals evolving from both sides of the political spectrum to date are being directed toward expanding entitlements whether it be extended child leave, "free" healthcare, "free" college education, etc. Our question is what will it take for a consensus for controlling entitlements to gain traction. So far we are at a loss.

Chart I Ratio Automatic Stabilizers to Unemployment Gap

Table I Deficits, Automatic Stabilizers and Related Data as a Percent Of GDP

Deficit (-)

Automatic

Deficit (-)

ex stabilizers

Unemployment

stabilizers

% of GDP

Stabilizers

ex stabilizers

Revenue

Outlays

Gap

/ Gap

2007

-1.1

0.1

-1.2

17.9

19.1

-0.4

-0.2381

2008

-3.1

-0.2

-2.9

17.1

20.1

0.4

-0.5714

2009

-9.3

-1.7

-7.6

15

22.7

3.6

-0.4482

2010

-8.3

-1.9

-6.4

15.2

21.6

4.7

-0.4086

2011

-8.1

-1.6

-6.5

15.4

22

4

-0.398

2012

-6.6

-1.2

-5.4

15.6

21

3.2

-0.3797

2013

-4

-1.1

-2.9

17

19.9

2.6

-0.4297

2014

-2.8

-0.9

-1.9

17.8

19.7

1.5

-0.5229

2015

-2.4

-0.4

-2

18.3

20.2

0.6

-0.625

2016

-3.2

-0.4

-2.8

17.9

20.6

0.2

-2.1053

2017

-2.9

-0.2

-2.7

17.9

20.5

0

-0.6126

Chart II National Defense Spending and Interest on Debt $Billions

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please note that this article was written by Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC. and is used with the permission of both.