January 23, 2008
CBO released its budget and economic outlook this morning, and the House Budget Committee held a hearing on the topic. I am pasting below the notes for my oral remarks at that hearing. (For video of the hearing, click webcast.) The outlook report is put together by a large team of analysts and editors at CBO. It is deeply impressive to see how well the team works together in producing a document of this complexity! ------------------ NOTES FOR ORAL REMARKS First, the economy has been buffeted by several inter-linked shocks, and the risk of recession is significantly elevated relative to normal economic conditions.
- After a dramatic runup in housing prices during the first half of this decade, housing prices have started to decline and many forecasters expect further drops this year.
- The weakening of the housing sector directly affects the economy through a reduction in residential investment, and indirectly affects the economy through reduced consumer spending as a result of lower housing wealth
- Problems in the mortgage markets have spilled over into broader turmoil in financial markets, which poses the risk of impeding the flow of credit essential to a modern economy
- Energy prices have also increased substantially. Although the effect of increases in the price of oil on the macroeconomy is smaller than in the 1970s and 1980s, the rise in oil prices is still a drag on the economy
- The combination of these forces has not yet fully manifested themselves, although the unemployment rate has ticked up. Indeed, the three-month moving average unemployment has now risen by 0.4 percentage points relative to the same period last year, which has only and always occurred in conjunction with a recession over the past three decades.
- On the other hand, other measures that typically have accompanied that large an increase in the unemployment rate at the onset of a recession such as a steep rise in unemployment insurance claims have not as yet occurred. Indeed, initial UI claims have recently ticked down just a bit.
- Especially with the most recent and notable action by the Federal Reserve yesterday, many professional forecasters are projecting continued -- albeit sluggish -- economic growth in 2008, rather than an outright recession.
- One bright spot to date, reinforcing the view of continued but slow growth rather than recession, has been net exports. Thus far, the depreciation of the dollar that is a necessary component of correcting our nations external imbalance has been gradual. And that has helped to stabilize and then even slightly improve the current account deficit, as net export growth has improved with the depreciation of the currency and continued growth abroad.
- The bottom line that the risk of recession is substantially elevated, but CBO expects, along with most professional forecasters, a period of unusually weak growth rather than outright recession.
- In particular, CBO expects growth for the year as a whole of under 2 percent and an increase in the unemployment rate to an average of 5.1 percent.
- A reflection of this slowing economic activity is that job growth fell by half between 2005, when it averaged 220,000 per month, and 2007, when it averaged 110,000. We expect it to fall in half again to 55,000 per month during the first half of 2008.
Let me now turn to the budget outlook.
- We have already seen some slowing of revenue growth, especially in corporate income taxes, and CBO expects further slowing this year.
- Our baseline suggests that among other factors, the slowing economy will boost the deficit to $219 billion, or 1.5 percent of GDP, this year.
- If Congress provides the additional funding for operations in Iraq and Afghanistan requested by the Administration, the deficit would rise to $250 billion. And if a fiscal stimulus package is enacted, the 2008 deficit could be substantially higher and at least from a ST stimulus perspective, that could be desirable.
- Thereafter, under the baseline, the budget moves toward balance in 2012. However, as many people have noted, that baseline excludes various policy changes that are widely viewed as likely to occur.
- For example, the baseline assumes no further AMT relief, and so the AMT substantially expands its reach.
- If one instead continued AMT relief, extended the 2001 and 2003 tax legislation past the scheduled 2010 expiration, adopted an alternative scenario for the future global war on terrorism, and increased the rest of discretionary spending in line with GDP, the outcome is substantially different than the baseline. Instead of a small cumulative surplus between 2009 and 2018, the result would be a deficit of about 3.5 percent of GDP.
Even over the next 10 years, the nations longer-term budget pressures begin to manifest themselves.
- Caseloads on both Medicare and Social Security are projected to rise. SS beneficiaries rise from 50 million in 2008 to 64 million in 2018. Projected increases in caseloads account for about 30 percent of the growth in mandatory spending between 2008 and 2018.
- More fundamentally, the cost per beneficiary in Medicare is projected to continue rising significantly faster than income. As a result, Medicare and Medicaid spending rises from 4.6 percent of GDP to 5.9 percent; Social Security from 4.3 to 4.9.
- Thereafter, under the long-term budget outlook we released in December, health care costs increasingly dominate the federal budget.
- Under the alternative fiscal scenario embodied in our long-term budget outlook, the nation's fiscal gap over the next 75 years amounts to 6.9 percent of GDP.
- Most of that is not due to an aging population
Given the ST economic environment and LT fiscal imbalance, let me end by briefly discussing a report that CBO wrote for this committee and the Senate Budget Committee on fiscal stimulus options.
- In particular, when the economy is particularly weak, the key constraint on short-term economic growth is demand for the goods and services that firms could produce with existing resources.
- In most circumstances, by contrast, and certainly over the long term, the key constraint on economic growth is the rate at which firms capacity to produce is expanded, through forces like increases in capital and labor and improvements in productivity.
- When the constraint on short-term growth is aggregate demand, as appears to be the case today, both monetary and fiscal policy can help by boosting spending.
- On the fiscal policy side, the automatic stabilizers built into the budget will help to attenuate any economic downturn by providing a cushion to after-tax income.
- The question is whether additional fiscal action is necessary. One way to think about it is that fiscal stimulus can help provide insurance against the risk and severity of a possible recession.
- Our estimates suggest that stimulus of between and 1 percent of GDP or so would reduce the elevated risk of recession to more normal levels, as long as the stimulus is well-designed.
- The stimulus need not be targeted at what caused the economic weakness. Instead, the key is that it bolsters aggregate demand and thereby helps to jump start a positive cycle of increased demand leading to increased production, until the constraint once again becomes how much we can produce rather than how much we are willing to spend.
- So what would work? A well-designed fiscal stimulus would have several central principles:
- First, it would be delivered rapidly. A problem with some efforts at fiscal stimulus in the past is that they took too long to take effect -- in a matter of months, not years. If the purpose of fiscal stimulus is to reduce the risk and severity of a recession, it would need to take effect quickly. Stimulus delayed is stimulus denied, and could even prove unnecessary and potentially counterproductive if delayed so long that it takes effect after the period of economic weakness has passed.
- Second, it would be temporary. As just mentioned, the nation faces a severe long-term fiscal gap. Stimulus that exacerbates that long-term budget imbalance could impose greater economic costs than benefits.
- Finally, it would be cost-effective, in the sense of boosting aggregate demand as much as possible at a given budgetary cost.