conversableeconomist

Searching for Plausible Budget Projections

The official federal budget projections are dishonest. They make future budget deficits look smaller by enacting spending cuts and tax increases that won\’t kick in for some years–but then then Congress and the President postpone or eliminate those changes before they actually take place. As a result, the nonpartisan Congressional Budget Office has for some years offered two sets of budget projections: the \”extended baseline scenario\” is based on what current law says will happen in the next 10 years; the \”alternative fiscal scenario\” assumes that certain changes aren\’t going to be made, and thus probably presents a more realistic picture. The CBO\’s 2011 Long-Term Budget Outlook shows the difference.

Start with the basic projection of how much debt the U.S. economy will accumulate in the next 25 years. The \”extended baseline scenario\” says that the rise in the debt/GDP ratio has pretty much topped out at this point, and will rise to a little over 80% of GDP by 2035. The \”alternative fiscal scenario\” is much more grim, suggesting that the debt/GDP ratio would approach 200% of GDP by 2035. Just to be clear, this forecast doesn\’t mean that the U.S. government would actually be able to borrow this much–only that we are on a debt accumulation path that looks unsustainable.

What are the different underlying assumptions here? Take a look at the different paths of taxes and spending in the two scenarios.

On the tax side, the \”extended baseline\” scenario has a bunch of tax increases arising in future years: for example, the expiration of the Bush tax cuts of the early 2000s, a gradual rise in the revenues collected by the alternative minimum tax, and others. As a result, it is based on federal taxes collecting 23% of GDP by 2035–far above the level seen in recent decades. In contrast, the \”alternative fiscal scenario\” is that federal taxes in the long-term will be more-or-less at their historical average for the last few decades of 18% of GDP.

On the spending side, both scenarios show that in the future, when you are asked for a short description of what the federal government actually does, the appropriate answer will be \”retirement and health care spending.\” The two scenarios don\’t differ in projected Security spending. In Medicare spending, the \”extended baseline scenario\” incorporates cuts to physician pay in the future; the \”alternative fiscal scenario\” says that physician pay will remain at 2011 levels. Also, in the \”extended baseline scenario,\” CBO explains that \”government spending on everything other than the major mandatory health care programs, Social Security, and interest on federal debt—activities such as national defense and a wide variety of domestic programs—would decline to the lowest percentage of GDP since before World War II.\” In the alternative scenario, these other areas of government spending remain at the current levels as a share of GDP.The other big spending difference is that the \”primary spending\” lines shown here leave out interest payments on past borrowing, which grow MUCH larger with the larger deficits in the the \”alternative fiscal scenario.\”

Of course, one can quibble with the details of what is assumed in the \”alternative fiscal scenario.\” But from where I sit, the official budget predictions in the \”extended baseline scenario\” look intentionally misleading, and the CBO is performing a public service by offering more plausible projections. 

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Comparing Oil Price Shocks

James D. Hamilton has short essay in the \”Research Summaries\” section of the NBER Reporter on \”Oil Price Shocks.\”

In one interesting figure, he compares oil price shocks of 1862-1865, 1973-1981, and 2002-2009. He argues that a common factor in each of these episodes (not the only factor!) was \”declining production from the maturing oilfields on which the world had been depending at the time\”: specifically, the decline of the Pennsylvania oil fields in the 1860s, the decline of U.S. oil production starting in the 1970s, and the fall in oil production from mature oil fields in the North Sea and in Mexico in recent years.

Hamilton also argues that \”in fact all but one of the 11 U.S. recessions since World War II were preceded by a sharp increase in the price of crude petroleum,\” and presents an intriguing table showing some patterns for the five recessions before the Great Recession.

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Caballero #3: The Pretense of Knowledge Syndrome in Macroeconomics

This is the third of three posts based on an interview that Ricardo Caballero of  MIT did with Douglas Clement of the Minneapolis Fed.

Caballero on the pretense-of-knowledge syndrome in macroeconomics:

\”[T]he economy is so complex that there is little hope of understanding much without models. I just don’t want these models to acquire a life that is independent from the purpose they are ultimately designed to serve, which is to understand the functioning of real economies…. [T]he current core of macroeconomics has become so mesmerized with its own internal logic that it begins to confuse the precision it has achieved about its own world with the precision it has about the real one.

\”There is absolutely nothing wrong with building stylized structures as just one more tool to understand a piece of the complex problem. My problems with this start when these structures take on a life on their own, and researchers choose to “take the model seriously”—a statement that signals the time to leave a seminar, for it is always followed by a sequence of naïve and surreal claims….

\”My point is that by some strange herding process, the core of macroeconomics seems to transform things that may have been useful modeling short-cuts into a part of a new and artificial “reality.” And now suddenly everyone uses the same language, which in the next iteration gets confused with, and eventually replaces, reality. Along the way, this process of make-believe substitution raises our presumption of knowledge about the workings of a complex economy and increases the risks of a “pretense of knowledge” about which Hayek warned us in his Nobel Prize acceptance speech.\”

The interview questions here are focused on a paper by Caballero called \”Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome.\” that was published in the Fall 2010 issue of my own journal, where Caballero spells out these arguments in greater detail.

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Caballero #1: Demand for Safe Assets in the Financial Crisis

The Minneapolis Fed publishes a magazine called the Region that has consistently excellent interviews with leading economists. The June 2011 issue has an interview with Ricardo Caballero, who is chairman of the MIT economics department. To avoid making this post of encyclopedic length, I\’m going to break it into three parts: Caballero on the demand for safe assets in the financial crisis, on moral hazard concerns during a financial crisis, and on how to do macroeconomics these days. But the excerpts in these three posts just scratch the surface of the interview, and the whole thing is worth reading.

Here\’s Caballero on what he sees as the underlying root of the financial crisis: a global shortage of financial assets, and especially highly-rated fixed income assets. In describing the financial crises, he says:

\”It’s a story in two steps. The first, present at least since the Asian crisis, is that the world has experienced a shortage of assets to store value. Emerging and commodity-producing economies have added an enormous demand for assets that is not being met by their limited ability to produce these assets. I believe this global asset shortage is one of the main forces behind the so-called global imbalances, the low equilibrium real interest rates that preceded the crisis, and the recurrent emergence of bubbles. Contrary to the conventional wisdom, I think these phenomena are not the result of loose monetary policy, but rather the other way around: Monetary policy is loose because an asset shortage environment would otherwise trigger strong deflationary forces. …

\”This is the second step, which began in earnest after the Nasdaq crash, when foreign demand for U.S. assets went back to its historical pattern of being heavily concentrated on fixed income … and especially on highly rated instruments. …The enormous demand for U.S. assets, with a heavy bias toward “AAA” instruments, could not be satisfied by U.S. Treasuries and single-name corporate bonds, and that imbalance generated huge incentives for the U.S. financial system to produce more “AAA” assets. As a result, we saw both the good and the bad sides of the most dynamic financial system in the world, in full force. Subprime loans became inputs into financial vehicles, which by the law of large numbers and by the principles of tranching were able to create \”AAA\” instruments from those that were not. …

\”Unfortunately, by construction, AAA tranches generated from lower-quality assets are fragile with respect to macroeconomic and systemic shocks, when the law of large numbers doesn’t work. That is, this way of creating safe assets may be able to create micro-AAA assets but not macro-AAA assets. In other words, these assets were not very resilient to macroeconomic shocks, even though they might have technically met AAA risk standards. …

\”In principle, this was not a big issue, but it became a huge one when highly leveraged systemically important institutions began to keep these macro-fragile instruments in their balance sheets (directly, or indirectly through special-purpose vehicles, or SPVs This was an accident waiting to happen; AIG and the investment banks should have known better, but the low capital charges were too hard to resist.\”

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Two ways of illustrating the financial crisis

When I\’m talking about underlying causes of the financial crisis, it\’s nice to have a vivid graph to display.

For example, I\’ve often used graphs showing how certain key interest rates spiked during the crisis. Here\’s an example of such a graph from the the CBO\’s August 2009 The Budget and Economic Outlook: An Update (p. 35). 

The graph shows the spread between the benchmark LIBOR interest rate and the federal funds rate
starts bubbling with the crisis in fall 2007, spikes in September 2008, then drifts down to near-common historical levels by spring 2009.The problem with this figure, of course, is that explaining it to an audience means needing to explain LIBOR, and the federal funds rate, and why a movement of a few percentage points is so important. If I wave my hands a lot, I can sell it. But I\’m not sure the audience knows what it\’s buying.

So here is my new favorite graph for illustrating the financial crisis. It\’s a graph of net financial lending, taken from the CBO\’s January 2011 Budget and Economic Outlook: Fiscal Years 2011 to 2021 (p. 33).

This graph needs a short explanation of what net lending is (that is, new lending minus repayments and charge-offs). But seeing a graph that goes up and down over the decades since 1950, but then turns violently negative the aftermath of the crisis, really helps to give a visceral sense of what a financial crisis means.