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The Federal Fiscal Predicament: What Seems Better is Actually Worse

Charles Blahous | 06/27/2013
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Of late there has been a great amount of discussion of whether federal deficit reduction should remain a national policy priority. While bipartisan fiscal watchdog groups like the Committee for a Responsible Federal Budget continue to argue that it should be, there have been plenty to argue that it should not. Some of the latter have even suggested that the deficit problem is now essentially under control, and that arguments to contain further federal debt accumulation serve a “political calculus” rather than a substantive need.

The debate is intriguing because of what it reveals about the complex relationship between perceptions and reality. To gain some perspective on this, consider the following projection of federal debt as a percentage of our Gross Domestic Product (GDP).

Virtually any economic policy maker would look at this projection and see cause for deep concern. It shows federal debt rising uncontrollably in relation to our total economic output, a trend that can only result in a crowding out of national savings, slower economic growth, lower standards of living, and an ultimate inability to sustain our debt payments.

This projection was in fact made. And when it was, there was wide agreement that it represented an unsustainable fiscal situation that threatened our economic well-being and warranted legislated corrections. Then-Director of the Congressional Budget Office (CBO) Peter Orszag testified about this projection that, "A substantial reduction in the growth of spending, a significant increase in tax revenues relative to the size of the economy, or some combination of the two will be necessary to maintain the nation's long-term fiscal stability." The Brookings Institution’s Tax Policy Center also declared flatly of this projection, “current budget policy is not sustainable.” They, and many others who made similar statements, were right.

The projection displayed in that graph and referenced in the aforementioned quotes is actually from CBO’s Long-Term Budget Outlook as published in December 2007, specifically its fiscal scenario that assumed the continuation of then-current tax and spending policies. (That fiscal scenario was widely held to be more realistic than CBO’s other “extended baseline” scenario in which, among other unlikely outcomes, then-current tax rates would all be allowed to expire at the end of 2010. Throughout this article I will refer to various updates of CBO’s projections; to maintain consistency I will always refer to this particular projection scenario.)

What has happened since these dire projections were released? The fiscal picture has become worse -- much worse. The worsening was due to the severity of the Great Recession, the tepid recovery that followed it, and aggressive federal deficit-spending in response to it. The fiscal picture deteriorated markedly from December 2007 to June 2009, as shown on the next graph of updated projections for federal debt.

This worsening happened because between these two CBO reports the federal government engaged in a burst of deficit spending partially caused by, and partially a deliberate policy response to, the recession. Though some argued that the long-term fiscal picture might actually be improved by increased federal “stimulus” spending in the near term, the spending binge greatly accelerated the approach of the previously-projected debt crisis.

One additional year later -- as of June 2010 -- nothing had happened to improve the fiscal outlook. Instead projections of federal debt accumulation had grown slightly further worse.

CBO next updated these long-term projections in June 2011. Doing so showed that the long-term fiscal picture had grown still worse, with the near-term debt picture looking substantially worse.

In June 2012, CBO updated its long-term projections again. The worsening of the near-term outlook shown in its 2011 report remained on the books. The long-term picture remained extremely bleak: slightly better than in the 2011 and 2010 reports (due in part to some fiscal discipline enacted as part of the 2011 Budget Control Act), but a little bit worse than the 2009 projections and still much worse than the late 2007 projections that had been understood to represent a dire fiscal threat.

CBO has not yet updated its long-term budget outlook published last year. Its latest projections show the projected fiscal outlook over just the next ten years (through 2023). The following graph cuts off at year 2023 for that reason.

That’s a lot of clutter for one graph, so let’s reduce it to two lines -- the earliest projection and the latest one -- to see how things have evolved since we were warned of an unsustainable fiscal outlook in December 2007.

The above graph shows that we are in much worse fiscal shape now than we thought we would be before the Great Recession hit, though even back then it was understood that our fiscal path was unsustainable. Following are some of the salient details of the comparison:

  1. Our near-term debt situation is now much worse than was foreseen at that time.
  2. Our long-term debt outlook is also worse than was foreseen at that time.
  3. The fiscal picture has grown so much worse that federal debt as a percentage of GDP has already far surpassed levels that the dire projections of late 2007 didn’t foresee happening until more than a decade from now.
  4. By any objective measure, if the fiscal picture was serious in late 2007 and warranted substantial deficit-reduction measures, it is far more serious now and requires more aggressive corrections.

Despite all this, as mentioned above, there are some today who are arguing that the fiscal challenge is now so well under control that policy makers should put it aside for now and concentrate on other concerns. Given the data, how can this be?

The answer may be rooted in the cognitive phenomenon of “anchoring” well-known in behavioral economics. “Anchoring” is basically a cognitive illusion in which an initial perception distorts our evaluation of subsequent data. An individual who believes he will end a transaction with $10 but comes away with $50 is happy. The same individual, if he previously believed he will end the transaction with $100, will come away unhappy with the same $50. The actual welfare of the individual is the same in both cases, but his subsequent attitude about the transaction is heavily influenced by his prior expectations.

Since December 2007 we’ve had several CBO reports in which the fiscal outlook has grown much darker, but also some recent ones in which it briefly appeared a little bit worse than it now is. This phenomenon can create skewed perceptions of federal finances. The last few years of massive deficit spending have objectively made our fiscal situation much more problematic. But at the same time, they have caused the large deficits we now continue to run to be misperceived by some as a return to reasonable fiscal health.

Rationally, it cannot be the case that our fiscal situation was made better by being made worse. But that is exactly the misperception that our last few years of massive deficit spending have apparently created in some quarters. As policy makers look at our fiscal situation, they need to remain on guard against illusion, recognize an untenable fiscal outlook for what it is and take responsible action to deal with it.