The bipartisan US Congressional Budget Office (CBO) recently published its annual Budget and Economic Outlook and it is a must-read for anyone interested in a comprehensive overview of where the US economy is heading in the next 10 years.
Of course, some readers do have lives, so I will try to summarize some key findings.
First, the headline-grabbing part of the report: The CBO projects that the US federal budget deficit will cross the $1-trillion threshold in 2020, two years earlier than previous estimates. Though the deficit has been this large before, that was during the aftermath of the greatest financial crisis since the Great Depression, when banks, insurance companies, and automakers needed federal bailouts to stay afloat.
Closing in on $1-trillion budget deficit after the second-longest economic expansion since the end of World War II — 36 quarters and counting — is a dangerous game. But there is an additional critical risk embedded in the CBO’s budget deficit projections: They only anticipate a modest decline in tax revenues.
The CBO’s growth projections may be too optimistic.
In general, the CBO makes reasonable estimates as to the 10-year growth forecasts that drive the lion’s share of the projected tax revenue. Yet the CBO makes one crucial mistake: It predicts US growth to average 2.3% per year between 2018 and 2028, up from a 1.8% average estimate in June 2017.
Now, recent US tax reforms may well spur growth by 0.5% per year over the next decade, but the CBO calculations are far too rosy when it comes to productivity growth.
Again, those of you with lives may not be aware, but there is a big debate in economic circles about why productivity growth has slowed to 0.7% per year since the financial crisis and an upcoming monograph from the CFA Institute Research Foundation will summarize the presentations given at a recent conference at the Museum of American Finance. Though productivity growth has been on a more or less steady decline since the end of World War II, nobody has adequately explained why it has been so low since 2008 or what the appropriate level should be going forward. Yet the CBO assumes productivity growth will increase to 1.1% on average during the next decade compared to 0.7% over the last 10 years.
The rationale? Productivity growth is mean-reverting and should return to its 25-year average.
Anyone who has ever designed econometric models knows they tend to have a regression to historic means built into them. But just because it is built in does not mean it will happen. If productivity growth has been on a downward trajectory since 1945, there is no fundamental reason why that trend will not continue.
So a more defensive approach to productivity growth might anticipate current rates to hold steady rather than accelerate to some historic average.
If that’s the case, GDP growth in the next decade would average 1.8% to 1.9% rather than 2.3%. That means an additional revenue loss of $1.1 trillion over the next 10 years, according to Appendix A of the CBO report. What would a loss of that much revenue entail? Using what the German pessimist in me would call “more reasonable assumptions,” I’d expect a rapid increase in the deficit.
In fact, the deficit would cross the $1-trillion mark in 2019 and potentially the $2-trillion mark in 2028.
The Budget Deficit and the US Dollar
The CBO study is silent on what this all means for the US dollar. But it will mean something. Sadly, modeling exchange rate dynamics is one of the most boring subjects I can imagine. But most models do not work all that well and macroeconomic variables have a vanishingly small impact on exchange rates.
A recent working paper from the Peterson Institute for International Economics underscores this point. Though the author, William R. Cline, focuses on the revenue-raising effects of a border tax adjustment (BTA), he also explores the implications of a tax cut measuring about 2% of GDP. Though the recent tax reduction turned out to be about 1% of GDP, we can halve Cline’s results to get a sense of how big the reduction in tax revenue will be. That can give us some insight into the corresponding effect on US interest rates and the US dollar exchange rate.
So what does that corresponding effect amount to? Not much.
A tax cut that reduces revenues by about 1% of GDP would increase the long-term Treasury yield from 3% to 3.25%, according to the model. This should lead to lower investment activity and an appreciation of the dollar. That appreciation would be remarkably small — a mere 2.1% relative to current levels.
In other words, don’t expect higher deficits to have much of an influence on the dollar.
But do expect those larger deficits to affect international trade. Using this model, the US trade deficit will increase by $50 billion in nominal terms, or $80 billion in real terms. At a time when the US administration is adamant about reducing the country’s trade deficit, the indirect effects of recent tax reforms are unlikely to inspire much joy in the White House.
How to Balance the Budget
So how can this runaway budget deficit be tamed? If the recent tax cuts are not reversed, spending cuts will be required. Unfortunately, the federal budget is increasingly boxed in between rising mandatory spending for Social Security, Medicare, and Medicaid, and rising interest payments for Treasury securities. Cuts in mandatory spending may be popular in some quarters, but they’re uniquely unpopular among the general public and very hard to accomplish politically.
Moreover, mandatory outlays and net interest costs add up to 16.6% of GDP on average over the next 10 years, according to the CBO baseline projections. Total revenues in comparison measure 17.5% of GDP. That means discretionary spending will have to be slashed almost to zero. But the biggest chunk of discretionary spending is the defense budget, which amounts to 2.8% of GDP, and cutting it is all but impossible.
The CBO projections illuminate three worrisome trends for the United States:
- There is less and less flexibility in the US budget. The recent tax cuts have reduced this flexibility further.
- Achieving a more sustainable deficit is going to be very, very hard. Eliminating the deficit altogether in the next 10 years is practically impossible.
- To put the country on a more solid financial footing, everyone in the United States will have to swallow a toad in the form of higher taxes and cuts in social security, health care, and defense spending.
In short, the United States has only bad options. Nevertheless, there are potential remedies, unorthodox and otherwise, that could rein in the budget and put the country back on a more sustainable growth path.
Michael S. Falk, CFA, has outlined how the US can reform its entitlement system in his excellent CFA Institute Research Foundation monograph Let’s All Learn How to Fish . . . To Sustain Long-Term Economic Growth. After the rather depressing CBO report, we all could use Falk’s more optimistic outlook.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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Joachim Klement, CFA, is a trustee of the CFA Institute Research Foundation and offers regular commentary at Klement on Investing. Previously, he was CIO at Wellershoff & Partners Ltd., and before that, head of the UBS Wealth Management Strategic Research team and head of equity strategy for UBS Wealth Management. Klement studied mathematics and physics at the Swiss Federal Institute of Technology (ETH), Zurich, Switzerland, and Madrid, Spain, and graduated with a master’s degree in mathematics. In addition, he holds a master’s degree in economics and finance.