Congressional Budget Office
Douglas W. Elmendorf
Director’s Blog

After testifying yesterday at the House Budget Committee on the state of the economy and fiscal stimulus, this morning I testified before the Senate Budget Committee on another key aspect of the current economic downturn–the ongoing crisis in the housing and financial markets.

Policymakers have responded to the turmoil with a set of unprecedented actions. Thus far, a systemic collapse of the financial system has not occurred, and conditions have improved noticeably in some financial markets. Nevertheless, according to some analysts, U.S. banks and thrift institutions could be facing more than $450 billion in additional estimated losses on their assets—on top of the approximately $500 billion that has already been recognized. The scale of those losses suggests that many financial institutions and markets will remain deeply troubled for some time, which will keep borrowing exceptionally costly for many borrowers and thereby dampen spending by households and businesses.

Challenging conditions seem likely to persist for some time in the housing and mortgage markets as well. Housing sales remain weak, and construction activity continues to decline. With the housing market’s large glut of vacant properties, the prices of homes are likely to fall considerably further, pushing the value of more borrowers’ homes below the value of their outstanding mortgages. As more of those “underwater” borrowers experience losses of income during the current recession, rates of delinquency and foreclosure on residential mortgage loans are likely to rise further.

In short, turmoil in the financial markets is likely to continue for some time, even with vigorous policy actions (and especially without them). A crucial and challenging question for policymakers is, What further actions can be taken to normalize the financial and housing markets so as to spur economic activity?

There are many options, none of them are perfect, and an effective policy probably requires a multifaceted approach that uses a range of tools to address the different aspects of financial distress. The costs to federal taxpayers of actions to reduce mortgage foreclosures and improve financial conditions are highly uncertain and may be large, but the economic consequences of doing nothing may be even greater.

My written testimony (link here) provides information on interventions implemented by the government to date and alternative strategies going forward.

To deal with the faltering financial system, analysts have proposed several, possibly complementary, strategies:

• One is to inject additional equity into institutions, perhaps by continuing the Capital Purchase Program under the TARP. This approach was widely supported by economists, often on the grounds that it would give the banking system the capacity to absorb losses and continue making loans without requiring the government to decide how much to pay for particular troubled assets.  However, the extent of losses and the fog of uncertainty about which institutions have suffered the losses may mean that further broad-based equity injections are not the most cost-effective way to proceed now.
• Another strategy is to deal with the troubled assets directly. This could be accomplished by the government buying assets, guaranteeing assets, or subsidizing the separation of assets into so-called “good banks” and “bad banks.” This approach could clarify the true condition of institutions’ balance sheets by removing the difficult-to-value assets, and allow bank managers to focus their attention on new lending rather than old problems. However, this approach would require the government to set a price for the assets on guarantees.
• Yet another strategy is for the government to increase its own lending to households and businesses. This could include developing new programs or expanding existing ones such as the Fed’s commitments to buy certain mortgage-backed securities and consumer-loan-backed securities. The basic idea is to provide public credit until the financial system is sufficiently healed to provide enough private credit.

CBO is required by law to report semiannually on OMB’s assessment of expenditures under the Troubled Asset Relief Program (TARP).  Today, CBO released the first of these reports.  (For more on the TARP program, this blog post from October includes CBO’s analysis of the financial rescue legislation).

Through December 31, 2008, the Treasury disbursed $247 billion to acquire assets under that program. CBO valued those assets using discounted present-value calculations similar to those generally applied to federal loans and loan guarantees, but adjusting for market risk as specified in the legislation that established the TARP. On that basis, CBO estimates that the net cost of the TARP’s transactions (broadly speaking, the difference between what the Treasury paid for the investments or lent to the firms and the market value of those transactions) amounts to $64 billion—that is, measured in 2008 dollars, we expect the government to recover about three quarters of its initial investment.

The Office of Management and Budget’s (OMB’s) report on the TARP, issued in early December, only addressed the first $115 billion distributed under the program. CBO and OMB do not differ significantly in their assessments of the net cost of those transactions (between $21 billion and $26 billion), but they vary in their judgments as to how the transactions should be reported in the federal budget. Thus far, the Administration is accounting for capital purchases made under the TARP on a cash basis rather than on such a present-value basis—that is, the Administration is recording the full amount of the cash outlays up front and will record future recoveries in the year in which they occur. That treatment will show more outlays for the TARP this year and then show receipts in future years.

CBO released an economic and budget issue brief today that discusses the factors underlying the decline in manufacturing employment over the past several years. The manufacturing sector of the U.S. economy has experienced substantial job losses since 2000. During the recession of 2001 and its immediate aftermath, employment in the manufacturing sector fell by about 2.9 million jobs, or 17 percent. Even after overall employment began to improve in 2004, the decline in manufacturing employment persisted. By the end of 2007, with the slowing of economic growth, employment in the sector had edged down further, by half a million jobs. And, as of November 2008, employment in manufacturing had fallen yet again, by slightly more than 600,000 jobs. A significant number of additional losses is likely given the current weakness in the economy.

Although the decline in manufacturing employment in recent years is not a departure from long-standing trends—the sector’s share of total employment has been falling steadily for more than half a century—the recession of 2001 hit manufacturing particularly hard. And, in sharp contrast to the pattern observed during previous expansions, employment in manufacturing (as reflected in the total number of hours worked) did not recover as it usually does following a recession.

The decline in manufacturing employment between 2000 and 2007 stemmed as much from an absence of new hiring as it did from layoffs of individual workers and downsizing. Rates of both job losses and job gains have been lower since the 2001 recession than they were in the 1990s. Workers who lost jobs, however, have typically experienced longer stretches of unemployment than did workers who lost jobs in the previous decade.

The steep decline in manufacturing employment since 2000 is associated with two interrelated developments: rapid gains in productivity (output per hour) in U.S. manufacturing and increased competition from foreign producers. Productivity in manufacturing has risen by about one-third since 2000, and growth in that productivity has consistently exceeded that of the overall nonfarm business sector.

Competition from overseas helped spur U.S. firms to boost productivity, but that competition has also dampened demand for goods produced in the United States, despite domestic manufacturers’ efforts to reduce costs through productivity enhancements. Those same developments have also had some beneficial effects for many U.S. residents, including the ability to buy manufactured goods at relatively low prices.

This decline in manufacturing employment represents a reallocation of jobs among industries rather than a decline in total employment in the United States. Until recently, other sectors of the economy have more than compensated in terms of overall employment, as evidenced by the relatively low 4.7 percent unemployment rate that existed during early 2007 and the roughly 7.5 million net new jobs created in the U.S. between early 2004 and the end of 2007.

This brief was prepared by David Brauer with the assistance of Eric Miller, both of CBO’s Macroeconomic Analysis Division.

Under current law, rising costs for health care and the aging of the population will cause federal spending on Medicare, Medicaid, and Social Security to rise substantially as a share of the economy. At the request of the Ranking Member of the House Budget Committee, CBO released a letter examining the potential economic effects of (1) allowing federal debt to climb as projected under the alternative fiscal scenario presented in CBO’s December 2007 Long-Term Budget Outlook; (2) slowing the growth of deficits and then eliminating them over the next several decades; and (3) using higher income tax rates alone to finance the increases in spending projected under that scenario.

How Would Rising Budget Deficits Affect the Economy? Sustained and rising budget deficits would affect the economy by absorbing funds from the nation’s pool of savings and reducing investment in the domestic capital stock and in foreign assets. As capital investment dwindled, the growth of workers’ productivity and of real (inflation-adjusted) wages would gradually slow and begin to stagnate. As capital became scarce relative to labor, real interest rates would rise. In the near term, foreign investors would probably increase their financing of investment in the United States, but such borrowing would involve costs over time, as foreign investors would claim larger and larger shares of the nation’s output and fewer resources would be available for domestic consumption.

How much would the deficits projected under the alternative fiscal scenario presented in the December 2007 Long Term Budget Outlook affect the economy? For its analysis, CBO used a textbook growth model that can assess how persistent deficits might affect the economy over the long term. According to CBO’s simulations using that model, the rising federal budget deficits under this scenario would cause real gross national product (GNP) per person to stop growing and then to begin to contract in the late 2040s. By 2060, real GNP per person would be about 17 percent below its peak in the late 2040s and would be declining at a rapid pace. Beyond 2060, projected deficits would become so large and unsustainable that the model cannot calculate their effects. Despite the substantial economic costs generated by deficits under this model, such estimates greatly understate the potential loss to economic growth because the effects of rapidly growing debt would probably be much more disorderly and could occur well before the time frame indicated in the scenario.

How Would the Slowing the Growth of Deficits Affect the Economy? The minority staff of the House Budget Committee provided CBO with a target path slows the growth of budget deficits. In evaluating the economic effects of the target path, CBO did not examine how specific policies to achieve that path would affect the economy; instead, CBO limited its attention solely to examining how the deficits produced by the target would affect the economy, assuming that such effects would play out as they have in the past. (CBO has not evaluated either the political feasibility or the economic effects of reducing spending sufficiently to accomplish this path for the deficit. Furthermore, the spending and revenue targets provided by the Committee staff are not the only way to achieve a sustainable budget path. Alternative policies will have different effects on the economy, and changes in taxes and spending can exert influences on the economy other than the effects of reducing budget deficits.)

Under the target path, federal outlays excluding interest (that is, primary spending) would rise from 18 percent of GDP in 2007 to 20 percent in 2030 and then decline to 19 percent in 2050 and 13 percent in 2082. For almost all years, revenues would remain at 18.5 percent of GDP. Under those assumptions, the budget deficit would gradually increase to about 6 percent of GDP in 2040 but then would decline to almost zero in 2075. By 2082, the target path would generate a budget surplus of about 2 percent of GDP. Under this path, real GNP per person would continue to grow over the entire projection period, rising from about $45,000 in 2007 to about $165,000 in 2082 in inflation-adjusted dollars. By 2060 (the last year for which it is possible to simulate the effects of the alternative fiscal policy using the textbook growth model), real GNP per person would be about 85 percent higher under the target path than under the alternative fiscal scenario.

How Would Increasing Income Tax Rates to Finance the Projected Rise in Spending Affect the Economy? How would the economy be affected if the projected rise in primary spending under CBO’s alternative fiscal scenario (from about 18 percent of GDP in 2007 to about 35 percent in 2082) was financed entirely by a proportional across-the-board increase in individual and corporate income tax rates? Answering that question is difficult because the economic models that economists have developed so far would have to be pushed well outside the range for which they were initially developed.

Nonetheless, tax rates would have to be raised by substantial amounts to finance the level of spending projected for 2082 under CBO’s alternative fiscal scenario. Before any economic feedbacks are taken into account, and assuming that raising marginal tax rates was the only mechanism used to balance the budget, tax rates would have to more than double. Such tax rates would significantly reduce economic activity and would create serious problems with tax avoidance and tax evasion. The letter provides more details about possible scenarios. (Raising revenue in ways other than increasing tax rates would have a less marked effect on economic activity.)

Conclusion. The United States faces serious long-run budgetary challenges. If action is not taken to curb the projected growth of budget deficits in coming decades, the economy will eventually suffer serious damage. The issue facing policymakers is not whether to address rising deficits, but when and how to address them. At some point, policymakers will have to increase taxes, reduce spending, or both.

Much of the pressure on the budget stems from the fast growth of federal costs on health care. So constraining that growth seems a key component of reducing deficits over the next several decades. A variety of evidence suggests that opportunities exist to constrain health care costs both in the public programs and in the health care system overall without adverse health consequences, although capturing those opportunities involves many challenges.

Last month, I participated in an event on mortgage and housing markets with Alan Blinder of Princeton and Zanny Minton Beddoes of The Economist magazine. The event was co-hosted by the Woodrow Wilson School and The Economist, and video from it is now available here .

CBO issued a letter today reviewing a new investment policy recently adopted by the Pension Benefit Guaranty Corporation (PBGC). As part of its analysis, CBO reviewed the assumptions underlying PBGC’s decision and assessed the revised policy’s potential for affecting the corporation’s ability to meet its obligation to retirees and for increasing costs to taxpayers.

• Prior to February of this year, PBGC’s investment strategy was to hold about 75 percent of its portfolio in bonds, with the duration of those assets matched to the corporation’s obligations. The remainder of the portfolio was invested in equities. PBGC’s new strategy reduces to 45 percent its allocation to fixed-income assets, in order to increase the proportion devoted to equities (45 percent) and to further diversify into alternative asset classes (10 percent).
• The change in investment strategy represents an effort on the part of PBGC to increase the expected returns on its assets and to diminish the likelihood that taxpayers will be called on to cover some of its liabilities. The new strategy is likely to produce higher returns, on average, over the long run. But the new strategy also increases the risk that PBGC will not have sufficient assets to cover retirees’ benefit payments when the economy and financial markets are weak. By investing a greater share of its assets in risky securities, PBGC is more likely to experience a decline in the value of its portfolio during an economic downturn — the point at which it is most likely to have to assume responsibility for a larger number of underfunded pension plans. If interest rates fall at the same time that the overall economy and financial markets decline, the present value of benefit obligations will increase, and the pension plans likely to be assumed by PBGC will be even more underfunded as a result.
• The effect on taxpayers of the change in PBGC’s investment strategy depends on assumptions about future premiums and benefits and expectations about the government’s ultimate responsibility to covered retirees. Although the Employee Retirement Income Security Act of 1974 (ERISA) explicitly states that the federal government does not stand behind PBGC’s obligations, an implicit expectation exists among many market participants and policymakers that taxpayers will ultimately pay for benefits should PBGC be unable to meet those obligations. If policies governing future premiums and benefits remain unaffected by the new investment policy, taxpayer’s increased risk of substantial losses will be balanced by the higher expected returns that the new policy allows. However, if the higher expected returns mean that premiums are reduced or benefits increased relative to what would otherwise occur, plan sponsors or beneficiaries will reap some of the benefits of the change in investment policy, but taxpayers will bear the added risks.

CBO has released an updated report on the cyclically adjusted and standardized budget. The new report is a companion to the baseline budget projections published in CBO’s March 2008 Analysis of the President’s Budget.

The purpose of the companion report is to examine the budget balance after temporary factors, such as the effects of the business cycle or onetime shifts in the timing of federal tax receipts and spending, are removed. (For example, during recessions, the budget deficit tends to increase because of the automatic stabilizers built into the budget: tax revenue tends to decline and certain forms of government spending, such as outlays for food stamps and unemployment benefits, tend to increase.)

The report presents estimates of two adjusted budget measures: the cyclically adjusted deficit or surplus (which attempts to filter out the effects of the business cycle) and the standardized- budget deficit or surplus (which removes the effects of other factors in addition to those of the business cycle).

Under CBO’s baseline budget assumptions (which assume continuation of current laws and policies), the cyclically adjusted budget deficit–the total baseline budget deficit after adjusting for the effects of the business cycle–will rise from 0.9 percent of potential GDP in 2007 to 2 percent in 2008, in large part because of the intended effect of the Economic Stimulus Act, and then decrease in 2009 to 0.6 percent, in part from the removal of the effects of the stimulus legislation and also from an increase in revenue from the Alternative Minimum Tax (which would occur under current law). The standardized-budget deficit will increase by somewhat more, climbing from 1.1 percent of potential GDP in 2007 to 2.5 percent in 2008 (after which it declines to 0.9 percent in 2009).

CBO released its full analysis of the President’s budget today, following up on a preliminary analysis we issued earlier this month.  The budget estimates are the same as in that preliminary analysis, but today’s report includes a discussion of macroeconomic effects of the President’s budget along with other details.

CBO’s estimates of the economic feedback associated with the President’s proposals may be of most interest—that is, how enacting those proposals might affect the nation’s economy and how those economic impacts, in turn, would affect the federal budget. We used five different economic models that focus on varying aspects of the economy to estimate those feedback effects.  Such estimates depend on a variety of specific assumptions, but under any of the assumptions incorporated into today’s analysis, economic feedback would modify the budgetary effects of the proposals only relatively modestly—and the potential effects could either expand or reduce the proposals’ net budget impact. Between 2009 and 2013, for example, CBO estimated that the President’s proposals would add to deficits or reduce surpluses by a total of $336 billion, without considering any economic effects.  Our analysis indicates that macroeconomic feedback effects could raise the proposals’ cumulative impact on the budget deficit to as much as $410 billion or reduce it to about $185 billion.

The reason that the macroeconomic feedback from President’s proposals is relatively modest is that over the medium to longer run those proposals have both a negative effect on economic growth (that is, by increasing the budget deficit) and a positive effect on economic growth (for example, by reducing marginal tax rates). The net effect of these countervailing forces tends to be small.

As is now widely recognized, the economy is currently experiencing significant short-term weakness. The short-term effects of many budget policies in this type of unusual condition can vary dramatically from their long-term effects —and indeed, the short-term impact can often be opposite in sign from the long-term impact.

Analysts in CBO’s Macroeconomic Analysis and Tax Analysis Divisions prepared the analysis of macroeconomic feedbacks.  Those sections of the report were written by Benjamin Page, and the modeling was performed by Robert Arnold, Paul Burnham, Ufuk Demiroglu, Mark Lasky, Larry Ozanne, Frank Russek, Marika Santoro, Kurt Seibert, and Sven Sinclair. 

Analysts in CBO’s Budget Analysis and Tax Analysis Divisions prepared the baseline estimates and estimated the impact of the President’s proposals in the absence of macroeconomic feedbacks.  (The Joint Committee on taxation prepared most of the estimates of revenue proposals.)  Those sections of the report were written by Barry Blom, Pamela Greene, Robert Arnold, and Amber Marcellino.  

CBO, with contributions from the Joint Committee on Taxation, released an analysis of the President’s budget submission for fiscal year 2009 this morning. (I will be summarizing our analysis at a conference held by the National Association for Business Economists today.) A report that presents the full analysis of the President’s budget, including CBO’s assessment of its macroeconomic effects, will be published on March 19.

CBO’s analysis indicates that:

• If the President’s proposals were enacted, the federal government would record deficits of $396 billion in 2008 and $342 billion in 2009. Those deficits would amount to 2.8 percent and 2.3 percent, respectively, of gross domestic product (GDP). By comparison, the deficit in 2007 totaled 1.2 percent of GDP.

• Under the President’s proposals, the deficit would steadily diminish from 2009 through 2012, at which point the budget would be balanced; it would remain close to balance in most years through 2018. Several key factors contribute to these outcomes, however. In particular, the President’s proposals exclude funding for military operations in Iraq and Afghanistan after 2009, incorporate significant reductions in discretionary spending relative to the size of the economy, and project a substantial expansion of the impact of the alternative minimum tax (AMT).

• The President’s budgetary proposals would result in revenues that were $2.1 trillion below CBO’s baseline projections over the 2009–2018 period, largely because of proposed extensions of various provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). The proposals also would lead to outlays that were below CBO’s baseline projections—by an estimated $1.1 trillion over 10 years—because of a smaller amount of funding for discretionary programs and reductions in mandatory spending, particularly in spending for Medicare.

• CBO’s analysis reflects the recent enactment of the Economic Stimulus Act of 2008. The analysis also takes into account recent revisions to CBO’s economic forecast.

CBO released a new macroeconomic forecast today, in advance of a new set of budget baseline projections we will release in conjunction with our analysis of the President’s budget.  (We have occasionally issued these types of revisions before but they are relatively uncommon.)  The revision is motivated by three recent developments: new data about the weakness of the economy, actions by the Federal Reserve, and the stimulus package passed by the Congress and signed into law by the President.

CBO’s previous forecast, which was embodied in budget projections released in January, was finalized in early December 2007.  Data released since then––especially regarding the labor market––indicate that economic conditions are weaker than previously projected, and conditions in some segments of financial markets remain worrisome. Other indicators––such as production indices and information on retail sales and sales of new homes––also suggest a slowing in economic activity. At the same time, changes in monetary policy have been more substantial than CBO assumed in December, and fiscal policy stimulus has been enacted. The Federal Reserve reduced the target for the federal funds rate by 125 basis points in January, and financial markets anticipate further easing in the near future. In addition, the Economic Stimulus Act of 2008 will provide about $150 billion in tax rebates and business tax deductions in fiscal year 2008. CBO anticipates that the recent monetary and fiscal policy actions will provide significant support to the economy in 2008. The net effect of those developments since CBO’s previous set of projections is slightly stronger projected economic activity for 2008 (because the impact of monetary and fiscal policy stimulus slightly outweighs the deterioration in economic conditions absent those policy changes) and slightly weaker projected economic activity for 2009 (in part because the withdrawal of fiscal stimulus temporarily reduces economic growth). CBO’s projections are similar to the most recent Blue Chip consensus forecast, an average of the estimates of about 50 private-sector forecasters. Although CBO’s projections do not show the slowdown in economic growth becoming severe enough to meet the economic definition of recession, the risk of a recession remains elevated, and economic activity will remain subdued for some period as the economy continues to work through the effects of problems in the housing and financial markets and the high price of oil.  More specifically, CBO now forecasts that real GDP will grow by 1.9 percent in calendar year 2008 and 2.3 percent in 2009.   The previous projections had been 1.7 percent and 2.8 percent respectively for 2008 and 2009.