Wednesday, March 25, 2009

Longrun slowdown 

Another reason for the less optimistic forecast from CBO comes from their projection that, on average, long-run economic growth of natural or potential GDP will slow.

For the next few years, CBO projects faster growth than the Blue Chip, as the economy grows back toward CBO�s estimate of potential GDP (which corresponds to a high level of use of labor and capital resources). Still, the CBO forecast assumes that the gap between actual and potential output closes more slowly than in previous recoveries because of a persistent drag from financial markets, households� loss of wealth, the overhang of vacant houses, and weak economic growth overseas. Therefore, CBO projects that the economy does not return to its potential level until 2014.

In the 2015-2019 period, the projected rate of real GDP growth averages 2.4 percent. That rate is lower than during the period from 2010 to 2014, largely because there is no longer any gap to close between actual and potential GDP.

Projected growth from 2015 to 2019 is also below historical average growth rates, a difference that is more than accounted for by slower growth in the labor force because of the retirement of the baby boom generation. Over the postwar period, the labor force grew at an average annual rate of 1.6 percent; by contrast, we project it to grow only 0.4 percent per year in the period from 2015 through 2019. As a result, potential GDP grew 3.4 percent per year on average in the postwar period, but CBO expects that it will grow by only 2.4 percent annually...
The rate of the 'primary deficit' that one can maintain is the function of three elements: the current debt-to-gdp ratio, the growth rate of real GDP in the long run, and real interest rates. If the government can maintain productivity to have real GDP grow faster than long run rates, it can run a small deficit and still have the debt-to-GDP ratio move towards zero to avoid the possibility will view US debt as a Ponzi scheme. But as the growth rate of GDP falls or the real interest rate rises, even small budget surpluses might not be enough to stabilize the ratio, leading to calls for even higher taxes (or lower spending) to get it onto a sustainable path.

Note, CBO is giving a better forecast than private forecasters, but worse than the Administration. I find Doug Elmendorf's explanation quite sound, though if there's a huge savings response to the loss of wealth (and future wealth via higher implied future taxes), you might not see as large an increase in interest rates on government debt as one might guess historically.

Reinhart and Rogoff:
Assuming the U.S. continues going down the tracks of past financial crises, perhaps the scariest prospect is the likely evolution of public debt, which tends to soar in the aftermath of a crisis. A base-line forecast, using the benchmark of recent past crises, suggests that U.S. national debt will rise by $8.5 trillion over the next three years. Debt rises for a variety of reasons, including bailout costs and fiscal stimulus. But the No. 1 factor is the collapse in tax revenues that inevitably accompanies a deep recession. Eight and a half trillion dollars may sound like a lot. It is more than 50 percent of U.S. national income. But if one looks at the Obama administration's stunning budget-deficit projections, with exceedingly optimistic projections on growth and bank-bailout costs, we think the U.S. is right on track.