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More on Warren Buffett’s Growing Economic Pie, As Quantified by CBO

August 29th, 2008 . by economistmom

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.

5 Responses to “More on Warren Buffett’s Growing Economic Pie, As Quantified by CBO”

  1. comment number 1 by: Jim Glass

    The “not enough for our kids” issue aside (as I am a greedy sort of dad) it’s interesting to ponder what 50% [or the corrected 40%] per capita growth over the coming generation would do to the influence and standing of the US in the world’s various competitive arenas, if the other competitors achieve 100%, 200%, 300% growth over the same period.

    I don’t suppose we’d lose much standing to the Western Europeans, but it seems like it might accelerate the arrival of the Asia-centric world.

    The historian Niall Ferguson has suggested that the American Empire could be done in by Medicare (as opposed to the long wars, revolutions, and barbarian invasions that did in the other great empires). You may have just run the numbers on that.

  2. comment number 2 by: B Davis

    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.

    I agree. It seems to me that we are breaking a long-held generational contract by running up debt to simply fund our own consumption. Prior generations seemed to generally believe that debt should be used only for emergencies or investments. How else can one explain how are forefathers paid the debt off in 1835? Didn’t they know that they were incredibly poor compared to us and were entitled to some of our pie? No, they had a quaint belief that the future world belongs to the future generations. For example, following are a couple of quotes from Thomas Jefferson:

    “I sincerely believe… that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale.” –Thomas Jefferson to John Taylor, 1816.

    “We believe–or we act as if we believed–that although an individual father cannot alienate the labor of his son, the aggregate body of fathers may alienate the labor of all their sons, of their posterity, in the aggregate, and oblige them to pay for all the enterprises, just or unjust, profitable or ruinous, into which our vices, our passions or our personal interests may lead us. But I trust that this proposition needs only to be looked at by an American to be seen in its true point of view, and that we shall all consider ourselves unauthorized to saddle posterity with our debts, and morally bound to pay them ourselves; and consequently within what may be deemed the period of a generation, or the life of the majority.” –Thomas Jefferson to John Wayles Eppes, 1813.

    We have now become so clever as to devise a rationale by which we are justified in running up debt to pay for our excess consumption and leaving them to be paid by our children’s hoped-for prosperity. Fortunately for us, our forefathers were not so “clever”.

    In any event, I think it is very helpful to look at the growth of real per-capita GDP. Still, I think that even this figure may be somewhat misleading. Although our current real per-capita GDP may have doubled during the past generation, how many people living now (at least in the middle and lower classes) could live on half of their current incomes? We may have a higher standard of living due to advances in technology and medicine but the real cost of an acceptable standard of living has risen as well.

    For example, if we were willing to live with the exact same level of medicine as our parents, health care would likely get cheaper. Due to advances in technology and/or the development of cheaper procedures, the cost of all of the procedures that our parents enjoyed would likely drop. Assuming that the cost of labor remained the same, then the cost of health care as whole should get cheaper. Of course, a big “problem” is that new advanced procedures are discovered which provide better health care but at a higher cost. Do we propose to have our children forgo these medical advances so that we might consume more now? Of course not. But if we bury them in debt, that may end up being the effect. Hence, I think we would do well to consider the words of some of those quaint old fogies like Jefferson.

  3. comment number 3 by: economistmom

    B Davis: excellent quotes and insights–thank you. The other reason not to read too much meaning into the “per capita real GDP” figure is that it’s only a (very narrow) measure of economic well being on average. And we know that wealth and income inequality has been on the rise. This reminds us that it’s important not only that we not steal too much of our children’s aggregate economic pie; the way that pie gets distributed among our kids (and the rest of current generations) determines how much total pie our kids will need to achieve those adequate and fair standards of living for all.

  4. comment number 4 by: B Davis

    Thanks. I agree that wealth and income inequality has been on the rise. The rise in income equality is clearly visible in the third graph at this link. I was also reminded that there is some dispute about the accuracy of the government figures. The third graph at this link shows an alternate measure of real GDP growth. I believe that it is obtained chiefly by backing out many of the methodological changes that have been made to the deflation process. That is, I believe that it is largely related to the measure of inflation that is used to covert the nominal figures of GDP into the “real” figures. I have no way of judging whether the older or newer methodology of calculating inflation is more accurate. I remember thinking a while back that there was a limit to how much different measures of the CPI could differ over the long run. However, I later realized that, due to the fact that the basket of goods being compared is changing over time, it’s very difficult to get a definitive measure of how much prices have increased.

    I also became aware of how much the CPI can differ for different people. A person whose costs depend largely on energy costs (like a trucker) has been experiencing very high inflation recently. Likewise, a person who has very high medical costs has had a relatively high inflation rate. Hence, this is another way in which different groups are getting a different share of a hopefully-growing pie. This would seem like another reason for continuing the seeming tradition of simply using debt for emergencies (which is paid down after the emergencies) and investments.

  5. comment number 5 by: B Davis

    And we know that wealth and income inequality has been on the rise.

    I listened to a very interesting podcast of a talk on this topic yesterday. It’s titled “How Unequal Can America Get Before We Snap?” and was given by Robert Reich on April 5, 2005. I suppose that it was a very appropriate thing to do yesterday, he being a former Secretary of Labor! In any case, I later found that there is also a video of the talk, along with the podcast, at this link.

    The talk is an hour and 39 minutes but I found that it went very quickly due to its entertaining nature. He is a lifelong Democrat but seems to be pretty fair in his coverage of the topic. For example, he mentions the fact that inequality in income and wealth began accelerating around 1979 but does not mention Reagan as any sort of factor. The two main factors that he mentions are globalism and technology. In any case, I found it very informative and entertaining and would recommend it to anyone interested in the topic.