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Obama Budget Ducks Spending Cuts

Authors: Benn Steil, Senior Fellow and Director of International Economics, and Paul Swartz
April 11, 2011
Financial News

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“We're not going to be running up the credit card anymore,” President Barack Obama announced in introducing his 2012 budget. “We're going to have to get serious about cutting back on those things that would be nice to have but we can do without.”

Anyone listening would think that means spending less. Significantly less. But what is striking about the president's actual budget maths is how reliant it is on growth assumptions, rather than actual cuts in spending.

The president knows America is too fat for its height. But rather than put the country on a diet, he has told it to get taller.

To be sure, economic growth can do wonders in reducing a country's debt burden. The United States exited World War II with a federal debt level of 109% of gross domestic product (compared with 72% today). Yet by 1963, after 17 years of 3.5% average annual growth, the debt burden had shrunk dramatically, to a much more manageable 42% of gross domestic product.

Despite the obvious prospect of an enormous post-war peace dividend, only a third of this fall was accounted for by an excess of revenue over expenditure – growth did most of the heavy lifting.

Will growth do the job this time around? The president obviously believes so. His Office of Management and Budget estimates robust growth of 4.4% in 2013 and 4.3% in 2014.

These assumptions are, however, wildly in excess of private sector “blue chip” consensus forecasts. Private forecasts are 1.4 percentage points lower in 2013 and 1.5 percentage points lower in 2014. After 2014, the OMB and private forecasts are more in line, but the huge divergence for these two years is critical. If the private forecasts are used instead of the political ones, the president's projected deficit average for 2013 to 2021 would have to be marked up from 3.3% of GDP to 4.3%.

That's about $1.75 trillion more piled on to the national debt burden.

But why should we favour the private forecasts? The OMB has obvious motivations for excessive optimism, and the historical data suggest that it succumbs to them. Since 1976, the OMB has overestimated growth in the year after the budget by a substantial 0.5%. This compares with private forecaster upside bias of only 0.1%. In the case of the president's budget, however, there is reason to fear that the bias gap will actually be much larger. This is because when the OMB and private forecasts differ widely (defined as being greater than 1.4 percentage points), the OMB's upside bias rises to a whopping 1%.

It is not just the private sector that disagrees with the president. The Congressional Budget Office is also far more sober in its growth projections. The CBO projects 1.4 percentage points' lower growth in 2013, in line with private forecasts, and 0.9 percentage point lower growth in 2014. Whereas the president's budget implies a debt-to-GDP ratio which is roughly stable at 77% between 2015 and 2021, the CBO's projections put the debt ratio on an unsustainable upward trajectory, from 79% in 2015 to 87% by 2021.

This suggests strongly that the president, in addition to taking up more robust ideas to boost growth, will actually need to cut spending significantly just to meet his own modest deficit reduction goals.

Here is where history truly counsels pessimism. All the current hubbub in Washington about cutting non-defence discretionary spending, which the president only wants to freeze, is ultimately a sideshow. Even those cuts demanded by the most hawkish Republicans won't, on their own, reverse the rising debt ratio.

“There's only one way to {fix America's long-term budget problems},” the president's fiscal commission co-chair Alan Simpson rightly observed. “You dig into the big four, Medicare, Medicaid, Social Security, and defence,” which together represent 63% of federal spending.

In shying clear of Medicare, Medicaid, and Social Security in his budget, the president took a bow to the formidable political challenge posed by the first three. But what about defence, which alone accounts for 22% of federal expenditure? In spite of the ups and downs in the global peace index, history suggests that cuts in nominal defence spending are just as difficult to achieve. Going back to the end of World War II, nominal defence spending has almost never fallen. Declines in defence spending as a percentage of GDP have been achieved only through inflation or real GDP growth – not by spending cuts. The fiscal commission's report called for $34 billion in nominal defence cuts between 2012 and 2013, a time period during which the president's budget calls for increases.

The bottom line on the president's budget is that it relies on juiced-up growth forecasts just to set the country on a path to lower but still unsustainable budget deficits. In appointing a bipartisan commission to address the issue, he teased the nation into believing that he would rise to the magnitude of the task if they did. Yet now, with a divided Congress, he is leaving the commission majority high and dry, and doing so at a time when presidential leadership on the deficit is needed more than ever.

No, Mr President, America will not grow into its weight.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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