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CBO Report Shows Dangers to Economic Growth from Austerity

The Congressional Budget Office released their latest budget and economic outlook for 2012. CBO outlooks are frequently wrong, so we shouldn’t read a whole lot into this. But there are a few nuggets worth pulling out.

First, there really is no pressing deficit problem. While the FY 2012 deficit should clock in, according to CBO, at around $1.1 trillion, which is 7% of GDP (2 points lower than last year), over time, the deficits reduce to under $200 billion, and over the 2013-2022 ten-year window, the deficits average 1.5% of GDP. The national debt falls into a more stable debt-to-GDP ratio over this time. This is what some call the “do-nothing” deficit strategy. Simply not blowing holes in the budget will put the country on a sustainable medium-term path.

Sustainable, however, does not equal good. The budget deficit shrinks because of spending caps and other austerity measures locked in over the next decade. And those will have a deleterious effect on economic recovery, GDP growth and unemployment. Specifically, CBO projects that the economy will grow slower and create fewer jobs because of the various policies set to trigger in the next couple years:

In part because of the dampening effect of the higher tax rates and curbs on spending scheduled to occur this year and next, CBO expects that the economy will continue to recover slowly, with real GDP growing by 2.0 percent this year and 1.1 percent next year (as measured by the change from the fourth quarter of the previous calendar year). CBO expects economic activity to quicken after 2013 but to remain below the economy’s potential until 2018.

In CBO’s forecast, the unemployment rate remains above 8 percent both this year and next, a consequence of continued weakness in demand for goods and services. As economic growth picks up after 2013, the unemployment rate will gradually decline to around 7 percent by the end of 2015, before dropping to near 5½ percent by the end of 2017.

We’re really talking about a decade of catch-up growth after the 2008 financial crisis and Great Recession. And austerity – defined as tax increases and spending cuts, in this case – will have a dampening effect on the economy, especially in 2013. Surely, Congress will trot this out at the end of the year to say that we cannot raise taxes — like letting the Bush tax cuts expire — in a time of economic fragility. They might say we cannot cut the defense budget. They’ll conveniently forget about the rest of the spending. So while Senate Budget Committee Chair Kent Conrad blathers about deficits, the truth is that deficit-fighting should not occur now.

Because the tax hikes from allowing the Bush tax cuts to expire would mainly impact the rich, however, who would probably still keep up their consumption, it doesn’t follow that tax increases and spending cuts are equal in this manner. In fact, tax hikes on the high-end would have a far reduced economic impact compared to spending cuts on public policies that create jobs. But in general, when it comes down to it, CBO is saying that we should run higher deficits, as government becomes the spender of last resort in a time of economic stress. Pulling back at this juncture would have the same fiscal drag as state and local budget cuts have had, and also the same consequences that we’ve seen in Europe.

What’s more, CBO estimates that inflation will remain low throughout the next couple years, so that shouldn’t be a factor for a higher deficit. AND, 10-year Treasury notes are expected to remain in the historically low 2-3% range in 2012 and 2013. This represents a missed opportunity for the economy to borrow and spend and bring the economy back to trend faster, which over time will increase revenues with more people working.

CBO also sees a crowding-out effect from mandatory spending. They write that “As a share of GDP, discretionary spending is projected to decline to its lowest level in the past 50 years by 2022.” Some of this will be offset by higher mandatory spending, mainly because of increased health care costs. But the low discretionary output, mainly because of the spending cap from the debt limit deal, represents most of the investment that government generates – education, research and development, innovation, etc. We’re eating our own seed corn.

One final thing. We’re likely to hit the debt limit this year.

New figures from the Congressional Budget Office indicate that the government will hit its debt limit before the end of the year — though exactly how long before is still unclear.

CBO predicts that on January 1, 2013, the debt subject to the overall limit will be just shy of $16.8 trillion. But the debt limit itself stands at $16.4 trillion. The Treasury Department can create some breathing space for itself using a series of extraordinary measures — but those only go so far.

“There is a risk that the treasury will hit its $16.4 trillion debt limit before the next presidential inauguration,” emails Moody’s chief economist Mark Zandi. “It will be close. I suspect the Treasury will have enough accounting wiggle room to get there, but much depends on whether the economy sticks close to script.”

You could see Treasury holding this off until the lame duck session, when a host of other issues have to get decided. But it looks like this Congress will have to make decisions on the debt limit once again.

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David Dayen

David Dayen