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CBO: How the Long-Term Budget Outlook Can Affect the Short-Term Economy

July 27th, 2010 . by economistmom

Nice issue brief just released by the Congressional Budget Office.  It explains that besides the “gradual consequences” of the gradual worsening of the fiscal outlook, there are these shorter-term risks to the economy:

Beyond those gradual consequences, a growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates. It is possible that interest rates would rise gradually as investors’ confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis. But as other countries’ experiences show, it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply. The exact point at which such a crisis might occur for the United States is unknown, in part because the ratio of federal debt to GDP is climbing into unfamiliar territory and in part because the risk of a crisis is influenced by a number of other factors, including the government’s long-term budget outlook, its near-term borrowing needs, and the health of the economy. When fiscal crises do occur, they often happen during an economic downturn, which amplifies the difficulties of adjusting fiscal policy in response.

If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation. To restore investors’ confidence, policymakers would probably need to enact spending cuts or tax increases more drastic and painful than those that would have been necessary had the adjustments come sooner.

In other words (or in “EconomistMom words”), the more we put off coming up with a sensible weight-loss program which combines a reasonable diet (spending restraint) with a decent amount of exercise (revenue increases), the more likely we’ll end up binging and purging–which is never a sustainable strategy.

And speaking of that optimal weight-loss program, the Center on Budget and Policy Priorities makes a recommendation for letting the upper-income Bush tax cuts immediately expire as scheduled, but permanently extending the “middle-class” portions proposed by President Obama.  My reaction is that’s still not enough exercise as well as not the most effective exercise.  More on what I mean by that later this week.

13 Responses to “CBO: How the Long-Term Budget Outlook Can Affect the Short-Term Economy”

  1. comment number 1 by: SteveinCH

    If people don’t mind, I’d like to slightly hijack the thread to talk about tax equity. I’ve been staring at effective tax rates and the relative relationships between rates at the top and the bottom of the scale.

    What I’m wondering if anyone can provide a principle-based answer for any particular level of progressivity in the tax code. I’ve not yet found anyone who can do so and I’m interested to hear the argument.

  2. comment number 2 by: SteveinCH

    Just read the CBPP link. Oddly every item of their argument against the tax cuts at the high end applies to all the tax cuts.

  3. comment number 3 by: VAT Brat

    SteveinCH,

    In the context of taxation, “Equity” is a euphemism for envy of others’ possessions. Ideally, you want to charge people (tax them) for the marginal cost of government services. Because so many services like defense, courts, and police have externalities that cannot be captured in this manner, we try our best with other kinds of taxes.

    In a society with envious citizens, it probably makes sense to level things a bit. You know, throw bread to the circus. Otherwise, a riot might break out, windows smashed, and possessions stolen. In other words, the tax system is a protection rackett run by elected officials in nice suits and skirts instead of spandex sweat suits with pinkie rings.

    With a virtuous citizenry, you can discuss libertarian nirvana, flat tax rates, limited government, etc. In the real world populated by people who believe they are entitled to have strangers pay for their medical care, we do the best we can and suffer with redistributionist policies that buy votes and sustain political power.

    You can dress it up with all the Karl Marx, John Rawls, John Galbraith, Noam Chomsky or other nonsensical philosophising you want, but it comes down to adopting a system that ameriolates the primordial urges of theft and domination, and labeling it as justice and equity.

    The alternative world is on display in Central America, Somalia, and other exciting parts of the world. They have low tax rates de jure, but high costs of doing business de facto.

  4. comment number 4 by: SteveinCH

    But I guess what I’m looking for is a defense of a particular level of progressivity. I get the defense of the concept but how do you justify any particular stopping point on the progressivity scale?

    To take a concrete example. If the government needs more money, how should the increment be distributed? Does the current or past distribution matter?

  5. comment number 5 by: VAT Brat

    Economistmom,

    Question: Suppose in 2008 before recession broke out, we had Clinton tax rates in place. Would you have recommended cutting tax rates in October 2008 as one response to recession?

    Question: Given that Bush tax rates were in place in 2008, has GDP grown faster than it would have had Clinton tax rates been in place?

  6. comment number 6 by: AMTbuff

    Steve, the answer is that more progressivity is ALWAYS better. Progressives can no more define a stopping point for taxes than for race-based preferences. The battle to equalize outcomes can never stop. To admit otherwise is to expose fundamental weaknesses in the guiding philosophy.

    Furthermore, as a practical matter, progressives cannot envision that outcomes will approach equality within their lifetimes. They are correct in this, because human beings are very different from each other, not as group members but simply as individuals.

    My next post goes back on topic.

  7. comment number 7 by: SteveinCH

    What’s annoying is that they won’t ever admit what you just said, if it’s true.

  8. comment number 8 by: AMTbuff

    If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation. To restore investors’ confidence, policymakers would probably need to enact spending cuts or tax increases more drastic and painful than those that would have been necessary had the adjustments come sooner.
    I’ve been preaching this here for months.

    What the CBO hints at is that investors are ALREADY frightened by this prospect and that this is slowing economic activity TODAY. This is my argument that resolving the long-term fiscal imbalance will STIMULATE the economy by removing this fear.

    The point that both progressives and conservatives will be horrified by the magnitude of taxes and spending cuts needed to balance the budget post-crash is one that Len Burman made well over a year ago. Len Burman is always right.

    If we could convince politicians of the truth of the preceding paragraph, they might act in time to avoid a crash. That’s a very long shot.

  9. comment number 9 by: AMTbuff

    Well what do you know: the CBO picked up the stimulus argument too, on the final page:

    “some studies suggest that certain types of fiscal austerity programs tend, at least in some circumstances, to stimulate economic growth.”

  10. comment number 10 by: BillSmith

    On Monday the CBO said the Social Security DI fund will run thru its trust fund by 2018. As in 0. Some same it will happen by 2016.

    Even 2018 is not a long time from now.

    At which point it dips into the other Social Security Trust funds. Given that, when do the other Social Security Trust funds run out?

  11. comment number 11 by: SteveinCH

    2018 I guess. There’s no money in there, just bonds. To redeem the bonds, they either borrow or raise taxes. If they borrow, it’s no different than if the bonds weren’t there at all.

  12. comment number 12 by: VAT Brat

    SteveinCH

    The “trust fund” bonds are claims upon future tax receipts with no legal status whatsoever. There is no party with any legal standing who can sue if they’re not “paid off.” It’s a delightful fiction conjured up by politicians to make seniors feel warm and fuzzy about the Ponzi scheme they’ve paid into all these years.

    Imagine this hybrid-privatization scheme as an alternative. You pay social security taxes into a mutual fund managed by the Treasury. The Treausry uses the tax proceeds to purchase Treasury Debt on the secondary markets. The value of your shares fluctuates over time, but you have a direct ownership interest in an asset. That asset is a fractional ownership interest in a pool with a government guarantee. Upon reaching retirement, your nest egg is a known quantity. If you want to impose regulations to ensure that seniors don’t withdraw too much too early and leave themselves destittute, then add that on if you wish.

    This solution addresses the Left-wing critics who say that privatization exposes seniors to the ravages of private equity markets with no guarantees. It addresses the right-wing critique of defined benefit programs (Social Security, Medicare) that have open-ended claims on taxpayer wallets.

    This is probably the only politically viable way of saving taxpayers from being over-burdened with Social Security obligations.

  13. comment number 13 by: AMTbuff

    VAT Brat, you can’t expect to get anywhere with people who think they have the ultimate answer that all the world’s best and brightest never thought of. There’s an attraction to these theories that works very similarly to conspiracy theories. You cannot talk someone out of it. They have to do their own digging with an open mind, and very few of them do so.

    People choose what to use for money. In prisons, it might be cigarettes. The medium has to be durable, divisible, portable, and some other things I forget at the moment.

    The fatal conceit of social engineers of all stripes is that the government can force the masses to act contrary to the laws of economics. It cannot. History has proven over and over that the public will choose an alternate currency when the old one loses its value too quickly. You can make it illegal, but it will happen anyway.