August 4, 2011
by Diana Furchtgott-Roth
President Obama and Congress have told the American public that the new law over which they wrestled for weeks, the Budget Control Act of 2011, will help the American economy.
That law will reduce government spending and the cumulative deficit by $2.1 trillion over the next ten years, as well as raising the debt ceiling to $16.7 trillion, a sum estimated to be sufficient until 2013.
Some, such as New York Times columnist Paul Krugman, have a different view of the effect of the new law. He believes that these spending cuts will hurt economic growth.
On July 31 Mr. Krugman wrote that, with a slowing economy, "the worst thing you can do in these circumstances is slash government spending, since that will depress the economy even further....Slashing spending while the economy is depressed won't even help the budget situation much, and might well make it worse."
But the Act does not "slash spending." It cuts $2.1 trillion over 10 years in discretionary spending-with no change to entitlements-from a baseline that was scheduled to grow over the next decades. After the cuts, discretionary spending remains flat, and entitlements continue to grow at a rapid pace.
Few people realize that congressional spending cuts for a given year are not subtracted from the prior year's spending. Rather, cuts are subtracted from a budget that grows on autopilot, particularly entitlement programs. That explains how Congress can cut spending by $2.1 trillion over 10 years yet produce a series of budgets that continue to grow.
To put the small magnitude of the spending cuts in perspective, $2.1 trillion in cuts over 10 years is only $600 billion more than the deficit for this fiscal year. It was estimated at $1.5 trillion, or 10 percent of Gross Domestic Product, by the Office of Management and Budget in February.
Missed in all the drama and controversy of the 11th hour fiscal compromise was this: despite the trillion-plus dollars spent on stimulus, last week the Commerce Department announced that GDP growth on an annualized basis for the first quarter of 2011 was only four tenths of one percent. For the second quarter, it was 1.8 percent.
The disappointingly slow pace of economic growth in 2011 implies that tax revenues (net of inflation) will likely be lower than forecast, and deficits over the next decade will be higher than previously assumed. Slower growth means fewer goods and services produced, more Americans out of work, less investment, and less tax revenue for the Treasury.
Moreover, slower growth means more government spending on unemployment insurance, Medicaid, Food Stamps, and other social programs.
That, in turn, may force the Office of Management and Budget and the Congressional Budget Office to raise their respective estimates for future federal deficits. Their new projections will come out later this month, in the annual summer revisions to the February budget.
These revisions may be as large, if not larger, than the amount the president and Congress claim to have just saved.
Could this be why Treasury Secretary Timothy Geithner set August 2 as the likely date that his agency would run out of money? If the date had been later, it would have been followed more closely by the budget reviews, which are likely to wipe out some, if not much, of the savings.
Using optimistic economic assumptions, OMB projected the deficit to be $7 trillion, or 3.7 percent of GDP, over the next decade. This was assuming a real GDP growth rate for 2011 of 3.1 percent, and growth rates for 2012 and 2013 of 4.0 percent and 4.5 percent respectively. The 2011 estimate appears impossible, given the sluggish first half, and the 2012-2013 estimates appear increasingly unlikely. Over the past 20 years, GDP growth, before inflation, has averaged 2.5 percent annually.
The revisions in GDP for the first half of 2011 could add billions to our 10-year deficit, if there is no countervailing spurt later in growth above forecast values. If GDP is lower than forecast through 2016, our deficit could be trillions higher over 10 years.
But forecasting is a tricky business. David Malpass, president of Encima Global, an investment research and consulting firm, told me on Wednesday that the budget revisions might make the fiscal year 2011 deficit smaller. The battles over spending earlier this year helped. Plus, estimated tax payments to the Treasury are strong because nominal GDP growth is in line with earlier forecasts.
What to do? Even if Mr. Malpass is right, Congress needs to cut government spending more than the Act specifies, especially for big ticket items such as entitlements, currently off the table.
The Social Security retirement age, headed by law now to 67 in 2026, needs to rise gradually even sooner, or further, or benefits need to be reduced. Or all three.
Medicare spending needs to be reduced. Democrats suggest the Independent Payment Advisory Board should determine what treatments are cost-effective. House Budget Committee Chair Paul Ryan has proposed transforming Medicare into a version of the Federal Employees Health Benefits Plan and reducing costs through competition.
Members of Congress, who may think they took a giant step this week towards fiscal responsibility, have only just begun to grasp the nettle. Politicians might pat themselves on the back for cuts of $2.1 trillion, but their hard-won agreement is only a small step to fiscal solvency.
Diana Furchtgott-Roth, former chief economist of the U.S. Department of Labor, was a Senior Fellow at Hudson Institute from 2005 to 2011.
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