Flash Point: ‘Co-opted By Optimism’

Just before New Years and the dreaded ‘fiscal cliff’, we played around with a possible article aimed at highlighting what we consider to be the real fiscal cliff: the unrepayable US sovereign debt. We studied the Wikipedia article on the fiscal cliff and in the end decided the complexity of the issue which was shortly to become a moot point, was not worth the resource expenditure. The article cited the work of the Congressional Budget Office (CBO) in analyzing the trajectory of the US debt under different scenarios. In particular, the following Figure stood out:

Figure 1. Two CBO debt projections into 2022 (click to open in new window).

Source: An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022

Our concern was that the CBO debt projections might be somewhere between optimistic and wildly optimistic, dependent on their economic and fiscal assumptions. For example, we doubt that their projections have an allowance for new wars although they consider military activity, but it is hard to imagine that the US will not be involved in at least one major new war in the next decade, especially if Kyle Bass (Kyle Bass: One Smart Man; see the Dec. 22 entry and video link) and others are right. In a more mundane vein, we wondered what the GDP estimates  were that they used. John Mauldin’s latest eletter, Somewhere Over the Rainbow motivated us to revisit the issue from the perspective of GDP.

CBO GDP Projections

We have assembled the CBO GDP projections for 2013 through 2022 in Table 1. ‘Nominal’ numbers are the headline numbers that the media publishes. ‘Real’ numbers are the nominal numbers adjusted for the effects of inflation.

Table 1. CBO annual real GDP growth projections, 2013 to 2022.

2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Avg.
Real GDP -0.3 3.1 4.8 4.5 3.8 3.1 2.6 2.4 2.2 2.3 2.4
Nominal GDP 1.3 4.6 6.5 6.5 5.9 5.3 4.7 4.4 4.3 4.3 4.0

Source: Table 2.1 from An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022

As can be seen from Table 1, their projection for the average annual growth in GDP is 2.4% real and 4.0% nominal. The CBO bases their deficit projections on an average annual GDP growth of 2.4% over the decade.

GDP Projections from the Smart Money

As mentioned in the introduction, John Mauldin reviewed forecasts by some of the top managers of Smart Money (private investors). Their projections are summarized in Table 2.

Table 2. Annual (assumed) real GDP growth projections, 2013 to 2022 by smart money managers.

Manager/Forecaster  GDP
Bill Gross of PIMCO 1.5%
Jeremy Grantham of GMO 1.4%
Dr. Robert Gordon for NBER <= 1%
Chris Brightman of Research Affiliates 1%

Source: Somewhere Over the Rainbow.

The striking divergence we see is that the GDP estimates from people that lose a lot of  money if they get it wrong, are half that of the CBO economists who remain ‘gainfully’ employed if they get everything wrong. We don’t discount their potential bias towards optimistic results either. These growth projections of the Smart Money we have written about extensively and are consistent with the trend in GDP growth we have documented.

The important of GDP projections is if they turn out lower than forecast, tax revenues decrease due to decreased economic activity. Entitlement program benefit payouts increase as unemployment increases. In short, if the CBO is wrong, their deficit projections are underestimated.

The real fiscal cliff is the point of default on the US sovereign debt. The repeated dramas of debt ceilings and legislation deadlines are simply sideshows staged along the way to the main event. This could be a decade or more away. Japan will go over the cliff first. They’ve held on now for a couple of decades, digging their hole deeper each year. A recent estimate we saw gives them 2-3 years tops. Europe will likely be resolved after that by a series of defaults until some fiscally stable scenario emerges. We think that this is a work in progress and may take 5 years to resolve as a guess. And the likelihood of a war is high too. No one can order these factors on a certifiable timeline but we think the relative order is reasonable.

In summary, we think the CBO acronym should be redefined as ‘Co-opted By Optimism’ as a comment on their deficit estimates. The implication is the debt will continue to grow at a greater rate than authorities expect, moving the real fiscal cliff – the day of debt reckoning – closer.

Addendum 20130103

Two relevant articles came to us today. One from CNN, 3 more fiscal cliffs loom,  shows how the fiscal cliff drama has simply been broken down and rescheduled as three separate dramas for early 2013. The other from David Kotok at Cumberland Advisors discussess the tax increase implications of the recent fiscal cliff deal: The Taxpayer Relief Act-a misnomer to celebrate the swearing in of the new Congress (hint: the title is a misnomer).

Addendum 20130104

Now we have an update from the CBO itself on the impact of the fiscal cliff deal: The “Fiscal Cliff” Deal. Key points are:

  • Like all of CBO’s cost estimates, our estimate for this legislation shows the effects of the legislation relative to current law at the time we did the estimate. Relative to the laws in place at the end of 2012, we estimate that this legislation will reduce revenues and increase spending by a total of nearly $4.0 trillion over the 2013-2022 period.
  • That dramatic widening of the budget deficit will increase interest payments on the federal debt, an impact that is not included in CBO’s cost estimates. The additional debt service will cost about $600 billion. Thus, if we added the estimated cost of the legislation and the related debt service to our previous baseline budget projections (which followed current law at the time), we would show additional deficits between 2013 and 2022 of roughly $4.6 trillion.
  • In our August Update, we projected that, under the laws in effect at the time, budget deficits from 2013 through 2022 would total $2.3 trillion. This legislation will boost deficits over that period by an estimated $4.6 trillion (including debt service costs). [This triples the deficit of their baseline case in Figure 1.
  • Although we expect that the legislation just enacted by the Congress will lead to higher output and income in 2013 we also expect that it will lead to lower output and income later in the decade than would have occurred under prior law.
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