Having combed through Warren Buffett’s post-I.O.U.S.A.-movie words on how the growing “economic pie” means we don’t really have to worry about our economy’s inability to handle the fiscal challenges ahead of us, I promised I’d try to quantify his point. So today’s first attempt comes entirely from the Congressional Budget Office (CBO) and their long-term macroeconomic and budgetary projections.
Faithful EconomistMom.com reader, “Brooks”, had pointed out to me that CBO’s long-term budget projections don’t account for the macroeconomic feedback effects associated with the different fiscal scenarios, and that’s indeed true. CBO assumes a path of real economic (GDP) growth that derives from their longer-term macroeconomic projections but is independent of the potential economic effects associated with the different tax and spending policies that are implicit in the different fiscal scenarios they consider. So in considering different fiscal scenarios, the budgetary projections CBO presents are based on the same assumed path of real GDP, which you can find here in these CBO data sheets (see the “real GDP” last tab).
Yet CBO doesn’t actually believe that policies that would lead to much larger deficits (such as their ”alternative fiscal scenario” compared with the baseline) would have no feedback effect on the macroeconomy. CBO just chooses not to model this feedback in making their long-term budget projections. (It’s really quite a major pain to model and requires an iterative, “general equilibrium” approach.) They do still discuss these macroeconomic effects in their long-term budget report.
On pages 11-15 of this report, CBO answers the query “How Would Rising Federal Debt Affect the Economy?” They explain it this way:
CBO’s two long-term budget scenarios would have different effects on the economy. Under the extended-baseline scenario, outcomes early on would be considerably more auspicious, but under both scenarios, the growth of debt would eventually accelerate as the government attempted to finance its interest payments by issuing more debt—leading to a vicious circle in which it issued ever-larger amounts of debt in order to pay ever-higher interest charges. In the end, the costs of servicing the debt would outstrip the economic resources available for covering those expenditures.
Sustained and rising budget deficits would affect the economy by absorbing funds from the nation’s pool of savings and reducing investment in the domestic capital stock and in foreign assets. As capital investment dwindled, the growth of workers’ productivity and of real wages would gradually slow and begin to stagnate. As capital became scarce relative to labor, real interest rates would rise. In the near term, foreign investors would probably increase their financing of investment in the United States, which would help soften the impact of rising deficits on productivity in the United States. However, borrowing from abroad would not be without its costs. Over time, foreign investors would claim larger and larger shares of the nation’s output, and fewer resources would be available for domestic consumption.
To be sure, budget deficits are not always harmful. When the economy is in a recession, deficits can stimulate demand for goods and services and bring the economy back to full employment. But the deficits that would arise under CBO’s long-term scenarios would occur not because the federal government was trying to pull the economy out of a recession but for a more fundamental reason: because the government was spending more and more for health care programs and for interest payments on accumulated debt. Over time, those deficits would crowd out productive capital investment in the United States.
When CBO gets into comparing the macroeconomic effects associated with their two main scenarios, their “alternative fiscal scenario” (where the Bush tax cuts are permanently extended via deficit financing and Medicare spending grows more rapidly than under current law) and their “extended-baseline scenario” (where the Bush tax cuts expire at the end of 2010 according to current law or any extensions are offset, and where Medicare growth is restrained by current-law rules), they explain they are ”comparing [macroeconomic] results under the scenarios with those from another set of assumptions under which the deficit in the long run is stabilized at roughly its percentage of GDP in 2007.” So it is a relative comparison, which obscures the Warren Buffett point that the “absolute” economic pie is growing over time. The question Warren Buffett left us asking at the end of I.O.U.S.A.: would our children’s economic pie still be larger than ours, no matter how or when we decided (or not) to take action to treat our fiscal imbalances?
It turns out that CBO’s underlying macroeconomic assumptions and their long-term budget analysis provide some answers to the Buffett question. Take the macroeconomic effects CBO quantifies on pages 14-15 of their report for their two fiscal scenarios, and use them to adjust the real GDP projections linked above. Under both scenarios, CBO describes the effect on the level of real GNP in 2040. (Note, that’s gross National product based on output produced by U.S.-supplied capital and labor, rather than the gross Domestic product (GDP) concept based on output produced within U.S. borders, used in the base projections, but I think it should be close enough.) Applying those relative declines in real economic output to the real GDP (base) projections (which correspond to what would be achieved under a stable deficit/GDP ratio), and comparing to the starting point of real GDP (in 2000 dollars) in 2007 (which is $11.7 trillion), here’s what you find:
“Base case” real GDP growth assumed by CBO (consistent with stable deficit/GDP), from 2007 to 2040: 108% (real GDP goes from $11.7 trillion in 2007 to $24.3 trillion in 2040–i.e., more than doubles). (This is the strong growth in the economic pie that Buffett is happy about.)
This GDP growth consistent with a stable deficit/GDP ratio is basically the same amount of real growth (108%) CBO expects over the same 33-year period under the “extended-baseline scenario”–because the deficit as a share of GDP is fairly sustainable within those first 33 years, even accounting for the potential negative feedback effect of higher tax rates (from scheduled expiration of the Bush tax cuts) on the macroeconomy. As CBO explains:
Although under the extended-baseline scenario, the higher tax rates in 2040 would reduce that growth, real GNP would still be 101 percent to 108 percent higher than it is today, CBO estimates. [implying real GDP in 2040 between $23.5 trillion and $24.3 trillion]
The modest effect that taxes have on the economy in those simulations stems largely from the fact that under the extended-baseline scenario, marginal tax rates would not increase very much between 2007 and 2040; instead, most of the additional revenues generated under the scenario would stem from a broadening of the tax base. If revenues were raised mainly through higher marginal tax rates, the economic effects would be more negative.
But the economic outlook under even the baseline-extended scenario becomes “more problematic” beyond 2040-50 as projected federal health spending rises dramatically (from around 10% of GDP in 2040 to more than 18% in 2080)–even with the lower growth rates scheduled under the “sustainable growth rate.” mechanism in Medicare.
Under CBO’s “alternative fiscal scenario” (deficit-financed extension of the Bush tax cuts and faster Medicare growth), the economic outlook is not nearly as good. CBO explains that the capital stock would be 25% smaller than under the base case and real GNP would be “about 13 percent” lower. Reducing 2040 GDP by 13% implies a real level of $21.2 trillion (in 2000 dollars), implying…
Real GDP growth under the alternative fiscal scenario, from 2007 to 2040: 81%.
…So even under the rather dire alternative scenario, a “stay the course” scenario of sorts where debt to GDP reaches nearly 200 percent by 2040, the economy is still larger in real terms. It’s smaller than it would be under the extended-baseline, current-law scenario, but it’s still larger than it is today. The economy my children will face when they are my age and in the prime of their working lives would still be 81% larger than the economy I live and work in today.
So, what’s the problem? Is this what Warren Buffett was getting at — 81 is bigger than zero?
Two questions then came into my mind: (i) how does this translate into per capita terms? –after all, the real economy has to grow in dollar terms just to keep up with population growth, otherwise people won’t be better off at all… and (ii) how does an 81 to 108% growth in real GDP over the next 33 years (a “generation”) compare with the growth in real GDP that has been experienced over 33-year periods in the past?
So I went back into the historical real GDP data (from the BEA) and the historical population (Census) numbers, and here’s what I found, going back 33 years to 1974 (when I was a child), and back another 33 years before that to 1941 (when my parents were children):
(***NOTE: GDP per capita growth rate calculations below have been corrected, 8/30.***)
- From 1941 to 1974, real GDP grew by 257%, and the U.S. population grew by 60%, so real GDP per capita grew by about ((257+100)/(60+100) = 2.23-1 =) 123%. In other words, as my parents’ generation went from childhood to the prime of their working careers, real GDP per capita more than doubled.
- From 1974 to 2007, real GDP grew by 167%, and the U.S. population grew by 41%, so real GDP per capita grew by about ((167+100)/(41+100) = 1.89-1 =) 89%. In other words, as my generation went from childhood to the prime of our working careers, real GDP per capita almost doubled.
In contrast, looking forward from now to 2040, as my children grow out of their childhood and into the prime of their working lives:
- From 2007 to 2040, real GDP would grow by just 81% if current policies were extended, and the U.S. population is projected to grow by 30% (according to Census projections), so real GDP per capita would grow by just ((81+100)/(30+100) = 1.39-1 =) 39%. That’s the increase in real GDP per capita that our kids (or grandkids) will face as they grow up.
Now, intergenerational fairness is certainly ”in the eye of the beholder,” and perhaps Warren Buffett might point out to me that 39 is still bigger than zero. But in my opinion, if my parents enjoyed economic growth of more than 100%, and if I’ve enjoyed growth of almost 100%, then it’s not fair that my kids would get growth of not even 40% –which is not even half of what I’ve enjoyed, and not even a third of what my parents enjoyed. And it’s not just because 40 is less than 100, but because that 40 could be closer to 60 maybe, if my generation just did the right thing and tried to be fiscally responsible–by, for example and for a start, paying for our own tax cuts that we want to keep after 2010. (Under the baseline-extended scenario, real per capita GDP growth over the 2007-2040 period would be 101 to 108%, and 208/130 = 1.60.)
A 40 percent larger economic pie for my kids, in my opinion, isn’t big enough, and isn’t “fair.” Not given past history, and not given how big it could be if we just stopped sneaking some of our kids’ pie for ourselves.