In a little over three years, our businesses have created more than 6.5 million new jobs.

… Corporate profits have skyrocketed to all-time highs.

… Our housing market is healing.

… And our deficits are shrinking at the fastest rate in decades.

If you studied my post last Wednesday on the CBO baseline update, this should strike you as an odd boast.

CBO projects that under current law we would have a deficit of 4% of GDP for 2013, meaning that our debt/GDP will continue to rise. CBO further projects that under the President’s budget we would have a deficit of 4.2% of GDP for 2013, slightly higher than their projected deficit under current law.

President Obama’s words:  Our deficits are shrinking at the fastest rate in decades.

Translation 1:  The rate at which we’re rolling backwards is slowing dramatically.

or Translation 2:  Our debt problem is getting worse much more slowly than in recent years.

That is not something you should boast about.  You’re supposed to boast when things are getting better, not when they’re getting worse more slowly.

CBO projects that revenues will increase significantly from last year (2012) to this year (2013) for three reasons:

• The tax increases legislated in the January 2nd “fiscal cliff” law;
• Some taxpayers realized their income in late 2012 rather than 2013 in anticipation of 2013 rate increases;
• For other reasons, personal income increased from 2012 to 2013.

These are all reasons why the U.S. Government is projected to collect significantly more revenues in 2013 than it did in 2012. In my earlier post I had mistakenly said these were reasons why CBO’s most recent baseline update had increased from January/February until now.

CBO’s Jan/Feb baseline document (and, indeed, their August baseline update last summer) had already incorporated tax increases scheduled to occur under then-current law. CBO did not leave them out of their Jan/Feb projection as I wrote earlier.

CBO’s revenue projection increased from their Jan/Feb baseline document to now simply because they have increased their estimate of the magnitude of the second factor listed above.

I apologize for any confusion I caused. While it’s important that I correct this, the error and correction don’t change the fundamental lessons from that post.

You can see the corrected post here.  Thanks to a friend for pointing out my mistake.

CBO released their updated economic and budget baseline today, in advance of their estimate of the President’s budget due out later this week. At first the headline sounds like good news: the deficit for this year will be “only” $642 B, 4% of GDP. That’s about $200 B smaller than CBO projected for this year in their January baseline document. Should we celebrate?

No, not unless you like the “fiscal cliff” tax rate increases and you like the government owning Fannie Mae and Freddie Mac. Those are the reasons why the deficit projection declined.

Deficits and Debt

You should know three benchmarks when thinking about federal budget deficits, each measured in % of GDP:

1. A roughly 3% deficit will hold debt/GDP constant;
2. The historic average deficit (pre-2008 crisis) is about 2% of GDP; and
3. Of course, a balanced budget is zero deficit.

Any time you hear a deficit number, compare it to zero, two and three, and you’ll have a good feel for where we are. A 4 percent deficit for this year is not good: it’s almost twice as high as the historic average, and it’s high enough that our debt will continue to increase faster than our economy will grow.

You will hear “But that 4 percent projection is much lower than the 5.4% projected in January. Surely that’s good news.  It is certainly an improvement over where we thought we were this year.”

This is where we need to review levels, rates of change, and expectations. This is tricky so I’ll break it down into small steps.

• The level of our debt/GDP is quite high: 73% at the end of last year.  That’s bad, and there’s a debate about just how bad it is.
• The deficit is the change in our debt for this year. A deficit means our debt is increasing, and a deficit greater than 3% of GDP means our debt is increasing relative to our economy. So our level is high (bad), and because our 4% deficit is greater than the 3% benchmark, our level is increasing (getting worse).
• But it’s getting worse much more slowly than it was getting worse a few years ago. In 2009 the deficit was 10% of GDP.  With a 4% deficit this year, our situation (level, debt/GDP) is getting worse much more slowly than it was four years ago.
• That does not, of course, mean we’re in a better position (debt level) than four years ago. Our debt/GDP at the end of 2008 was 41%. At the end of last year it was 73%, and CBO projects it will increase to 75% at the end of this year. That our debt is growing much more slowly this year than it was four years ago is hardly cause for celebration.
• Looking for a silver lining, our projected deficit (4%) is significantly smaller than was projected just four months ago (5.4%, projected in January). It is therefore a better (less bad, really) number than prior expectations.

I know that’s probably more complicated than you want.  Sorry, best I can do.

Why did the projection change so much?

Update:  I struck a lot of text from the original version of this post, in which I misread the reasons why CBO’s revenue projection went up.  The correct version is in green here.

• Based on tax data collected through April of this year, both income and corporate tax collections on income earned in 2012 (and therefore collected in 2013) are coming in higher than CBO anticipated;
• and Fannie Mae and Freddie Mac, now quite profitable, are making big dividend payments to the Treasury. These payments show up on the outlay side of the federal budget ledger, but they are in effect receipts of the U.S. government.

CBO’s best guess at this point is that the first factor is because taxpayers realized more income in late 2012 (rather than in 2013) in anticipation of 2013 rate increases than CBO had originally anticipated.

The other big consequence of the nature of these changes is that they are mostly one-time bumps. So the 2013 numbers improved quite a bit, but the numbers for following years don’t increase nearly as much.

Enough already! How should I feel about this?

If you supported the tax rate increases then this is marginally good news. But don’t celebrate; our fiscal picture is still grim.

If, like me, you hate tax rate increases on anyone and detest having the government own two massive mortgage finance companies, then you should feel no comfort from today’s deficit news, which is almost entirely the result of those policies. I’d happily return to a 5.4% deficit if you let me repeal the tax rate increases and replace Fannie & Freddie with a private mortgage securitization market.

And then I’d cut government spending.  A lot.

The key substantive point of the paper and op-ed is a $6.3 trillion number:

An exhaustive study by the Heritage Foundation has found that after amnesty, current unlawful immigrants would receive $9.4 trillion in government benefits and services and pay more than $3 trillion in taxes over their lifetimes. That leaves a net fiscal deficit (benefits minus taxes) of $6.3 trillion.

I expect making 8-9 million people here illegally into U.S. citizens would increase future deficits once these people are eligible for benefits. But there are so many problems with the Heritage study that this $6.3 trillion number is useless for making policy decisions. It might as well be plucked out of thin air.

Others have criticized the Heritage study, including a detailed critique from Cato’s Alex Nowrasteh. I’m adding to that here.

The basics of estimating government expenditures for an entitlement program are simple.

1. Figure out the number of people who will receive subsidies;
2. Figure out how much the government will spend, on average, per person per year;
3. Choose your timeframe, measured in years;
4. Multiply (1) by (2) by (3) and you’re done.

The Heritage study makes errors in each step.

1. The study purports to measure the “cost … of amnesty.” Let’s set aside whether amnesty is the appropriate word to describe what is in the Gang of Eight’s bill. The fiscal cost of “amnesty” is the incremental cost of making those here illegally eligible for government payments and services relative to what we have now. People here illegally are already imposing fiscal costs by driving on the highways, using public parks, relying on local firefighters for emergency services, and in some cases receiving uncompensated care in emergency rooms. Some children here illegally are already receiving free public education. Making those children U.S. citizens doesn’t increase the cost to the state of educating them.

There are significant incremental costs to amnesty, mostly from millions of people eventually becoming eligible for Social Security, Medicare, Medicaid, food stamps, and cash assistance.

But in addition to these incremental costs, Heritage incorporates all of the baseline costs in their $6.3 trillion estimate of “amnesty.” By measuring total rather than marginal costs, they are telling us the cost of making millions of people legal relative to the cost of somehow finding and deporting all of them. Setting aside my view that such an alternative is infeasible, it is inaccurate to describe such an estimate as the cost of amnesty. It is instead the cost of amnesty relative to some other state of the world that Heritage would prefer. That is both misleading and not particularly useful to policymakers.

The study authors acknowledge this. On page 29 of they write:

The $6.3 trillion figure represents the lifetime fiscal costs of unlawful immigrant households after amnesty. It does not represent the increased fiscal costs caused by amnesty alone. The increased lifetime costs caused by amnesty would equal $6.3 trillion minus the estimated lifetime fiscal costs of unlawful immigrant households under current law.

The killer problem comes with the way Heritage is marketing the study. $6.3 trillion is Heritage’s estimate of the total costs of illegal immigrants if “amnesty” is granted. But the op-ed is titled “What amnesty for illegal immigrants will cost America,” and the op-ed says “amnesty has a substantial price tag,” thus mistakenly presenting $6.3 trillion as the marginal cost of a proposed policy change. The study says one not very useful thing, while the op-ed markets the study’s results as something else entirely.

2. In addition to not being an estimate of the cost of “amnesty,” the $6.3 trillion number does not measure the cost of illegal immigrants, either. The study includes a number calculated from looking at 12.7 million people, then labels that the cost of “illegal immigrants.” Contained within those 12.7 million people are 4.5 million children born in the U.S. to at least one parent here illegally. These children are U.S. citizens. Heritage is inflating the population of “illegal immigrants” measured by 55% = (4.5 / (12.7 – 4.5)).

The Heritage logic is that those 4.5 million children are in the U.S. only as a result of illegal immigration, so the costs of providing them with taxpayer services are costs of illegal immigration. Heritage is correct that, had those 8.2 million adults here illegally never arrived, those 4.5 million children would not have been born in the U.S.

But you can’t unring the bell. Whatever your view on whether policy failed by granting citizenship to the U.S.-born children of an illegal immigrant, these children are now U.S. citizens and entitled to benefits (and with the requirement to eventually pay taxes). The fiscal costs of these citizen children can’t be counted as the cost of “amnesty for illegal immigrants,” since (a) they are being paid now and (b) they will continue to be paid even if their parents do not get benefits.

At best Heritage’s estimate is not the cost of “amnesty” for illegal immigrants. It is an estimate of the cost of “amnesty” for 8.7 million illegal immigrants plus the costs of benefits for 4.5 million U.S. citizen children.

While the study acknowledges that their estimate depends heavily on this unusual redefinition, the op-ed and Heritage’s subsequent promotional efforts do not. In the study the authors carefully acknowledge:

For example, any study that excludes the welfare benefits and educational services received by the minor U.S.-born children of unlawful immigrant parents from the costs assigned to unlawful immigrant households will reach very different conclusions about the fiscal consequences of illegal immigration.

The DeMint/Rector op-ed makes no such distinction and is factually incorrect because it includes the benefit spending for 4.5 million U.S. citizens (emphasis added by me):

… current unlawful immigrants would receive $9.4 trillion in government benefits…

As we’ll see next, the study is also not really a complaint about the fiscal effects of illegal immigrants, or even of immigrants generally. It is instead a complaint about low income people receiving net government subsidies.

3. The logic behind the study can be summed up like this:

• Poor U.S. citizens cost the government money because they receive more in benefits than they pay in taxes;
• Immigrants tend, on average, to be fairly low on the income scale;
• Illegal immigrants even more so; therefore
• Making illegal immigrants legal (at some point) will therefore increase future deficits.

But other than the “even more so” point, this isn’t really an argument about illegal immigrants. It’s an argument about the existence of low-income Americans, a redistributive safety net and old-age subsidies, and an income tax system that exempts about 45% of Americans from paying income taxes.

Senator DeMint and Dr. Rector write:

Yet immigrants should come to our nation lawfully and should not impose additional fiscal costs on our overburdened taxpayers.

I agree with the first part, but they run into trouble on the second.  If you believe their numbers, legal immigrants also impose additional fiscal costs on our overburdened taxpayers.

The Heritage logic would apply equally to legal immigrants and to babies born to low income U.S. citizens. I know Heritage is not opposed to either of those, but the logic of this study (and the language in the op-ed) would seem to lead to such a conclusion.

4. Even more generally, the study is actually a critique of our unbalanced federal budget for everyone, and not just for the poor, much less for a subset of the poor. The federal budget is terribly out of whack, the result of promising way too many entitlement spending benefits without raising the taxes needed to pay them. (I would of course solve this by changing the spending promises, not by raising taxes.) Entitlement spending promises to seniors are the largest cause of this problem and are the drivers of unsustainable federal and state government spending trends.

Illegal immigrants are being promised far more in benefits than they will pay in taxes not just because they are on average low income, but because almost everyone is being promised old age benefits that will exceed the taxes they will pay.

In addition, Heritage’s calculations mistakenly assume that Social Security and Medicare benefits will be paid in full to newly legal immigrants for the next 50 years, even though (a) it’s obvious that neither program’s spending is sustainable in its current form for even half that time; and (b) current law includes a mandated 27% cut in Social Security benefits once the Social Security “trust fund” has a zero balance, and a 13% cut in Medicare part A benefits when the Hospital Insurance “trust fund” hits the wall. As a result, Heritage’s estimates of the direct old-age benefit costs for newly legal immigrants are too high.

5. The authors do a lot of work to group illegal immigrants by educational level (as a proxy for income) and to estimate the fiscal costs for various eligibility phase-in timeframes. But, as best I can tell, they assume that a poor, low-skilled, poorly educated illegal immigrant will remain poor, low-skill, and poorly educated, and that he will draw government subsidies his entire life. Incomes typically climb as a worker ages (including for low-skilled, low-wage workers). Some people who arrive in the U.S. illegally may initially take jobs well below their skill level because of language barriers that they later overcome. Others will get further education or build skills over time. Since government subsidies relate inversely to income, if you assume illegal immigrants will never see their education, skills, or income increase, then you’ll overestimate the government subsidies spent on their behalf and underestimate the taxes they pay. Ignoring the potential for self-improvement and economic advancement inflates the cost estimate.

Let’s not forget that those here illegally are the subset of those back home who had some combination of skills, determination, and savvy to make it to the U.S. despite significant barriers.

6. More broadly, the fear of discovery and deportation has to constrain the labor supplied by those here illegally. A talented electrical engineer here illegally might now be working in an unskilled job because green card verification is weaker for driving a cab than for working at Cisco or Intel. A spouse here illegally might choose to stay at home with the kids rather than seek paid work because the former has significantly lower risk of being discovered by immigration authorities. Eliminating these deportation risks will increase the available labor supply. Increased labor supply means a larger GDP, a larger tax base, and higher government revenues. Heritage appears to ignore all these supply-side labor effects, which is unusual from an organization that in other contexts has championed consideration of supply-side effects in fiscal estimates.

7. To get their huge numbers Heritage sums up spending over a 50-year period. They adjust their estimates of future spending and taxes for inflation but not for the time value of money.  Most official legislative cost estimates are done for a 5 or 10-year period, in which these effects are small and customarily ignored. But nobody adds up a 50-year fiscal stream without either discounting it or measuring it as a % of GDP rather than in real $. Using a 3% real long-term interest rate (CBO’s assumption), a dollar of cost 50 years from now is equivalent to a 23¢ cost today. Heritage counts this cost as a dollar rather than 23 cents. They should be showing us net present values if they want to do long-term estimates. It’s tough to say exactly, but a back-of-the-envelope calculation suggests this almost doubles their final number.

8. Finally, the DeMint/Rector op-ed purports to describe what illegal immigrants “will cost America,” when in fact they are looking only at what they will cost American governments. This is an important oversimplification and a surprising one from an institution as reliably conservative as Heritage, which I would never expect to make the mistake of equating the Government with the Nation. I happen to think the cultural and non-governmental economic benefits of a robust immigration system and a resolution of the problem of a stock of 8-9 million people here illegally far outweigh the likely impact on the federal budget, but you might make a different judgment call. Either way, it’s obvious that the federal budget is only part of the calculus, and the op-ed erred in suggesting otherwise.

To summarize, the $6.3 trillion number offered by Heritage as “the cost of unlawful immigrants and amnesty”:

• Does not estimate the marginal cost of an amnesty program or whatever is in the Gang of Eight bill relative to anything other than a fantasy state of the world;
• Includes costs for 4.5 million U.S. citizen children in its estimate of the costs of illegal immigrants;
• Employs logic extensible to both legal immigrants and poor U.S. citizens, and thus is actually a critique of government tax-and-spending redistribution more than of illegal immigration;
• Mistakenly assumes that unsustainable Social Security and Medicare benefits will be paid to newly-legal immigrants for 50 years when both programs will go bankrupt long before;
• Ignores supply-side labor effects by mistakenly assuming that an illegal immigrant who is poor and receiving government benefits will remain poor for 50 years, that he will not learn new skills or increase his income, and that he will not find a better-paying job or take additional work after eliminating the risk of deportation;
• Ignores the time value of money; and
• Mistakenly labels the cost to the Government as the cost to the Nation, ignoring the cultural and non-fiscal economic benefits and costs of changing immigration policy.

There is a significant fiscal effect from making 8-9 million people into U.S. citizens and making them legal taxpayers and eventually beneficiaries eligible for the full panoply of government subsidies. But Heritage’s $6.3 trillion figure is not a good estimate of that effect and is useless for making policy decisions.

I am a fan of Heritage and respect many of their scholars and their policy work. Unfortunately this study and op-ed are not up to their usual standard. They subtract value from an informed policy debate about an important topic.

Let’s review:

• The sequester is modeled after a similar provision in law from more than 20 years ago.  That earlier sequester exempted certain programs from spending cuts, most notably Social Security, and it limited any Medicare cut to at most 2% 4%. These are the two largest entitlement programs in the federal budget.
• When the terms of this sequester were negotiated in the summer of 2011, the President’s advisors expanded the list of programs exempt from spending cuts to include most low-income/safety net entitlement programs. Most notable here is the exemption of Medicaid, the third largest entitlement. They also limited the Medicare cut to no more than 2%.
• In the summer of 2011 President Obama wanted the sequester to raise taxes as well but Congressional Republicans refused. For the past few months the President has been trying to rewrite the terms of that deal so that tax increases will be substituted for spending cuts, at least for the first year. His insistence has contributed to a stalemate.
• The sequester is now cutting spending in FY13 by the following percentages:
  • defense discretionary:  7.8% cut;
  • domestic discretionary:  5.0% cut;
  • Medicare:  2.0% cut;
  • small pots of defense and domestic mandatory spending are cut by almost the same percentages as their discretionary counterparts above.

tsaLet’s do a thought experiment: suppose the sequester now taking effect was instead structured as a true across-the-board spending cut?  Suppose we wanted to cut government spending this year by the same $85 B as is being cut now, but we didn’t exempt huge swaths of entitlement spending?  And suppose we cut all spending by the same percentage?

The discretionary programs now being cut by the sequester would take smaller hits. Let’s see how the numbers change.

In my hypothetical across-the-board spending cut I will exempt only interest payments and defense spending in a combat theater. Everything else, including all non-combat theater defense and the three largest entitlements of Social Security, Medicare, and Medicaid is on the cutting block along with all other non-interest, non-combat spending. And I’m going to cut everything by the same percentage rather than having a higher percentage cut for defense and a lower percentage cut for Medicare.

My arithmetic shows that such a true across-the-board spending cut would save the same $85 B this year through a 2.6% cut to all spending except interest and defense spending in a combat theater.

A true across-the-board spending cut would therefore be about one-third as deep of a cut in defense spending as the current sequester, and about half as deep of a cut in nondefense discretionary spending as the current sequester.

Seniors wouldn’t like a 2.6% cut in their Social Security checks, and the poor wouldn’t like the same percentage cut in Medicaid, cash welfare, food stamps, and other low-income support programs. Medical providers and health insurers wouldn’t like the larger cuts in Medicare and the inclusion of Medicaid and CHIP in the cuts.

But there would be upsides for other things the federal government does relative to where we are now. Let’s look at the effect of this alternative on spending this year for some popular programs relative to the effect of the sequester now in place. If we substituted a true 2.6% across-the-board spending cut for our current sequester, this year the federal government would spend:

• $300M more for Special Education;
• $732M more for medical research at the National Institutes of Health, $138M more for National Science Foundation grants, and $424M more for NASA;
• $124M more for the Food & Drug Administration and food safety;
• $131M more for airport security, $110M more for the FAA, and $23M more for air marshals;
• $333M more for the FBI;
• $139M more for immigration and customs enforcement and $242M more for customs and border protection;
• $53M more to operate the National Parks and $141M more for the Forest Service;
• $24M more for the Smithsonian;
• $54M more for child are and development block grants, and $238M more for children and families services programs;
• $195M more for global health programs;
• $142M more for the Coast Guard;
• and about $27B more for defense.

By insisting that the deficit reduction debate is a choice between cutting spending and raising taxes the President has frozen Washington in a stalemate position that is likely to last for the remainder of his term. If policymakers were instead to set the tax stalemate aside and examine more closely the choices they are implicitly making within the universe of government spending, they would see that by exempting huge swaths of popular entitlement spending from any cuts they are focusing the pain on programs that to many are more important and more popular.

Our federal budget process is fouled up in that it gives procedural advantages to entitlement spending over discretionary spending.  Benefit programs that primarily help particular individuals are advantaged, while programs that principally provide for the common good are disadvantaged.  The current sequester exacerbates those procedural advantages and, as a result, means that many broadly-supported functions of government are being cut even more that they would be if the spending cuts were distributed evenly across all government spending.

(photo credit: Anita Ritenour)

THE PRESIDENT: So economists are estimating that as a consequence of this sequester, that we could see growth cut by over one-half of 1 percent.  It will cost about 750,000 jobs at a time when we should be growing jobs more quickly.  So every time that we get a piece of economic news, over the next month, next two months, next six months, as long as the sequester is in place, we’ll know that that economic news could have been better if Congress had not failed to act.

And let’s be clear.  None of this is necessary.  It’s happening because of a choice that Republicans in Congress have made.  They’ve allowed these cuts to happen because they refuse to budge on closing a single wasteful loophole to help reduce the deficit.  As recently as yesterday, they decided to protect special interest tax breaks for the well-off and well-connected, and they think that that’s apparently more important than protecting our military or middle-class families from the pain of these cuts.

The President’s initial attempt to blame Republicans in Congress for current and future economic weakness is flawed because House Republicans passed a bill that would have the same macroeconomic effect as the President’s proposal, at least for this year.

CBO estimates the sequester will knock about 0.6 percentage points off the growth rate of GDP in calendar year 2013, and therefore that undoing the sequester (in 2013) would increase GDP growth by the same amount. For the moment I’ll set aside the concerns often expressed on the right about estimating the GDP effects of fiscal expansion or contraction and take CBO’s estimates as given.

The key flaw in the President’s argument is that the first year effects of the House-passed sequester replacement bill and the Senate Democrats’ failed bill are nearly identical.  Each would unwind almost all of the 2013 effects of the sequester, and each would therefore increase GDP growth by the same amount.

The proposals differ in the amount and composition of their deficit-reducing offsets, but in both proposals those would be spread out over a long timeframe beginning next year.  Senate Democrats proposed to offset in future years all of the $85 B they would spend this year, while House Republicans passed a bill that would reduce the deficit even more in future years. But $8 B (Senate Democrats) to $20 B (House Republicans) of deficit reduction for each of the nine years after this one is too small to show up in any estimate of macroeconomic effects. The competing proposals would have the same growth benefit this year, and similar and trivially small growth costs in future years, beginning in 2014.

The President says there wasn’t a deal because Republicans refused to accept his proposed offsets. House Republicans can make exactly the same argument. This 0.6 percentage point growth drag is because the two sides couldn’t agree, not because one party wanted to fix the problem and the other party didn’t.

I expect the President will fail to mention that CBO also says that the tax increases he championed and got will slow this year’s economic growth by an additional 0.6 percentage points this year on top of the effects of the sequester.

Sequester replacement was mostly for show

As best I can tell there were no negotiations across the partisan aisle on how to replace the sequester. The President did some campaigning outside of Washington. Even if he had expected Congressional Republicans to fold to this pressure, his team was not doing the staff-level work needed to actually make legislation happen. And while leaders of both parties claim to hate the sequester, neither side hated it enough to be willing to even begin negotiations over how to pay for its replacement. The competing sequester replacement plans and the rhetoric on both sides look like they were mostly for public positioning and Member management within the Congressional caucuses rather than serious attempts to change the law.

Why the sequester will hold

There are two distinct legislative coalitions that in theory could unwind the sequester. In both hypothetical coalitions cuts in both defense and non-defense discretionary spending would be unwound.

One would be a center-left alliance formed by pro-defense spending Republicans agreeing to raise taxes and cut farm subsidies. These Republicans would be deciding that avoiding defense spending cuts is more important than preventing additional tax increases.

The other would be a center-right alliance formed by Democratic appropriators agreeing to drop their party’s tax increase demands and pay for higher discretionary spending offset entirely by entitlement spending cuts. These Democrats would be deciding that they care more about spending money than about extracting more from the rich.

These coalitions will never form as long as the sequester issue is being controlled by the President and the four Congressional leaders. Each of these five is working principally to hold his or her party intact, and each has so far succeeded. A coalition to replace the sequester would have a chance only if the issue were being handled below the leadership level, most likely in the House and Senate Appropriations Committees. In these committees everyone’s priority is to increase discretionary spending and both sides would be more likely to show flexibility on offsets. Since the issue remains squarely in the hands of the President and the party leaders I expect the sequester will hold indefinitely.

In addition, the optical damage of the cuts affects only the next seven months. If the continuing resolution extends post-sequester spending levels, then the implementation of next year’s sequester won’t show up as a “spending cut,” but instead as a slight increase (say, +2% for inflation) from this year’s spending levels. To the extent the political and press blowback from cutting spending arises from the optics of a decline in spending, that decline takes effect only this year. After that it’s built into the baseline, at least in a political sense.

Watch the CR for spending flexibility and maybe a little money

I instead expect the appropriators to instead pursue more modest versions of the same goals through quietly shaping the upcoming Continuing Resolution. The appropriators appear poised to give targeted flexibility to the Administration in a few limited areas where they agree that the sequester will impose too much pain, and they might even try to shift a few billion dollars around here and there. The Administration claims they are still opposed to funding flexibility. I think they’re irrelevant on this point and the Appropriators will now quietly exert process and legislative language control to minimize the policy harm from the sequester. And the more flexibility the appropriators provide, and the more they shift funds (within what I hope is a fixed post-sequester topline) to address sequester-driven policy harm, the more likely the sequester will be sustained over time.

The White House’s management challenge

While Team Obama now says the sky will now drop gradually rather than fall suddenly, they are sticking to their line that the pain from these spending cuts will be intolerable and will/should force Congress to increase taxes and discretionary spending.

With this argument they create a management challenge for themselves. They need the harm from these cuts to be severe and visible. The more harm is done and felt, the more likely that Republicans will relent to the president’s position (or so goes this logic). More policy harm creates more legislative pressure.

But the TSA manager at O’Hare or Logan or LaGuardia wants to minimize policy harm in his area, not maximize it. Sure he’d like more funding, but from his perspective there’s little he can do to influence Congress on something as big as the sequester. And since he will personally take the public heat for long security lines in his airport, his goal is to make do as best he can and minimize the harm done by the cuts.

The same is true for every program manager throughout the government. Each is judged on how well her program meets its goals given the funding available. If we simply assume that these managers will try to do their jobs as effectively as possible, both for noble policy reasons and for personal reputational reasons, then they will be working at odds with the President’s strategic goal of maximizing visible harm to undo the sequester. They will be trying to minimize the damage done while the President wants the opposite.

Playing a longer game?

It is possible the President’s primary goal is not to replace the sequester with offsets that he prefers. Sure he’d prefer that policy outcome, but it’s hard to believe that he and his team were so clueless that they actually thought his recent barnstorming would cause Republicans to fold and agree to raise taxes. Again.

Charles Krauthammer has suggested the President is instead playing a longer game, that his strategic goal is instead to win Democratic majorities in 2014 rather than to win a tactical victory by extracting a few tens of billions of dollars now from the House Republican majority. If Mr. Krauthammer is right, then the goal of barnstorming is to further damage the Republican brand rather than to enact legislation in the short run.

The other obvious benefit to the barnstorming is that without a deal to replace the sequester, the President now has a new target for blame-shifting in his macroeconomic message.

• Old message: All economic bad news is George W. Bush’s fault, all good news is because my policies are working.
• New message: All economic bad news is Congressional Republicans’ fault, while all good news is because my policies are working.

Both these “long game” explanations are dispiriting. That doesn’t mean they’re wrong.

Let me repeat – nothing I’m proposing tonight should increase our deficit by a single dime. It is not a bigger government we need, but a smarter government that sets priorities and invests in broad-based growth.

Let’s set aside for the moment the question that others have raised, the credibility of his claim that his proposals will not increase the deficit. Even if the President’s new proposals don’t increase the deficit they will still make government bigger because they increase government spending.

The deficit does not measure the size of government. It instead measures how economic resources are allocated over time to finance government spending. When we increase the deficit we reallocate some future income to today for government to spend. When we reduce the deficit we are taking less future income to pay for today’s government spending.

When the President says he won’t increase the deficit, he is saying he will not increase the amount of future income taken to pay for increased government spending today. In effect he is promising not to create an additional burden to raise future taxes beyond what’s in current law. He is not saying he won’t increase government spending today and raise current taxes by an equal amount, which is what we mean by government getting bigger.

As a fiscal matter we should measure the size of government by the amount government spends, not by the difference between what it collects and what it spends (the deficit). Suppose in our $16 trillion economy you were to increase government spending by $320 billion per year and increase taxes by the same amount. The deficit would be unchanged but government would be $320 billion per year bigger.

For the 50 year period before the 2008 financial crisis total federal government spending averaged 20.1% of GDP. CBO tells us it’s 22.2% this year and projects that under current law it will average 22.1% over the next decade. That means the federal government is and will continue be 10% bigger than it his has historically been, relative to the economy. If we were to use real dollars rather than percent of GDP we’d measure an even bigger increase. As a fiscal matter the federal government is and will be significantly bigger than it has historically been.

If you increase government spending you make government bigger, even if you pay for that spending with higher taxes. To make government smaller, cut government spending.

In addition to fiscal expansion the federal government has also massively increased its regulatory scope in the past four years, especially in health care and financial services. The President proposes that in the next four years he’ll do the same to the energy sector.

President Obama is correct that we don’t need a bigger government. Unfortunately, that is what has resulted from his first term and what he proposes for his second.

Each year the federal budget cycle begins with release of the baseline from the Congressional Budget Office in a document titled The Economic and Budget Outlook. If you want to learn more about economic and fiscal policy I recommend you read carefully at least CBO’s short summary.

My former White House colleague Charles Blahous wrote a great piece that highlighted ten fiscal policy lessons you should draw from CBO’s latest baseline report. With this post I’d like to look at one important macroeconomic graph from that same report.

This graph compares actual GDP with what GDP would be “if everyone were working,” a rough description of what the economists call potential GDP. They estimate the lowest unemployment rate that they think would be consistent with inflation not accelerating. CBO thinks this number is 5.5%. They then estimate what economic output would be if we were at 5.5% unemployment rather than where we are, which is now 7.9%.

The gap between the light blue (actual GDP) and dark blue (potential GDP) lines above therefore represents an estimate of the output lost due to high unemployment. To the left of the dotted line that output gap is in the past and cannot be recovered. To the right of the dotted line we see CBO’s projections for actual and potential GDP in the future. We want actual GDP to converge with potential GDP, to “close the gap” quickly.

Now let’s zoom out and look at a similar historical graph measured in decades rather than years.

From this graph we can see that in the long run, actual GDP tracks closely with potential GDP, and that the recent output gap is quite large in comparison.

Let’s zoom back in and examine the recent past, the left half of CBO’s graph.

The downward sloping part of the light blue line is the recent recession, also marked by the vertical white stripe. If you look closely you can see actual GDP flattening out in early 2008 as potential GDP continues to rise. Actual GDP then plummets as the financial shock hits in the second half of that year. The recession ended and the recovery began where the line started sloping upward in mid 2009.

In trying to frame this story positively President Obama draws your attention to the fairly steady growth of actual (real) GDP since the recession ended, the upward slope of the light blue line from mid 2009. This graph also shows that in recent years actual GDP had been growing at roughly the same rate as potential GDP. Because the light blue and dark blue lines have almost the the same slope, the distance between them is almost as large now as it was when the recession ended. So while the President is right that the economy has been growing for 3+ years, the output gap is almost the same size as it was in mid 2009. We’re not catching up.

Here is how CBO describes it.

By CBO’s estimates, in the fourth quarter of 2012, real GDP was about 5½ percent below its potential level. That gap was only modestly smaller than the gap between actual and potential GDP that existed at the end of the recession because the growth of output since then has been only slightly greater than the growth of potential output.

To close the output gap we need much faster short-term economic growth than we have had over the past three and a half years. We need the light blue line to slope sharply upwards until it meets up with the dark blue line.

Now let’s turn to CBO’s projection for the future. I’ll hide the left half of the graph this time.

Now we can see more closely that CBO’s GDP projection has three significant features:

1. CBO projects that real GDP will continue to grow only as fast as potential GDP this year;
2. They then project that growth will accelerate; but
3. They project that the output gap won’t close until the end of 2017, almost five years from now.

Attaching numbers to this, CBO projects real GDP will grow 1.4 percent in 2013, 3.4 percent in 2014, and 3.6 percent per year from 2015-2017, reaching potential GDP at the end of 2017.

This translates into their (un)employment projections as well. CBO projects an 8.0% unemployment rate in the fourth quarter of this year and a 7.6% rate at the end of 2014, only three-tenths of a percentage point below where we are now. They then project that the unemployment rate will decline to reach full employment by the end of 2017.

On our current path CBO projects we won’t reach full employment for almost five more years.

CBO also estimated the total size of the output gap and it’s depressing:

With such a large gap between actual and potential GDP persisting for so long, CBO projects that the total loss of output, relative to the economy’s potential, between 2007 and 2017 will be equivalent to nearly half of the output that the United States produced last year.

You may have noticed that I have avoided discussion (here) of why the economy has grown so slowly, how much of that is because of or in spite of policy decisions, and why it’s projected to continue to do so for the next year. That’s where the food fight begins, including the debate about whether and how much the 2009 fiscal stimulus increased growth, and the debate about how much of slow future growth is because of business uncertainty about the economy, about drags from policy and regulation, and about allowing more time for balance sheet repair after the financial shock of 2008.

Those are incredibly important debates but today I just want to highlight the basic historic facts and a mainstream projection from an unbiased source. On our current policy path CBO projects continued slow growth for 2013 and a gradual acceleration after that, returning the U.S. economy to full capacity output by the end of 2017. That projection excludes:

• the downside risk to growth from policy shocks like further tax increases proposed by the President, repeated unresolved fiscal conflicts that exacerbate business uncertainty, and additional regulatory burdens rumored to be coming from HHS, IRS, EPA and financial regulators; and
• the downside risk to growth from possible external shocks from a possible Middle East crisis or a sudden unraveling of Europe’s financial system.

I told you this wasn’t a happy post.

Summary

• While the U.S. economy has been growing fairly steadily since the recession ended in mid 2009, it has been doing so far more slowly than we need. Actual growth has been just sufficient to keep up with growth in our national economic capacity.
• CBO projects that 2013 will be yet another year of slow growth with acceleration beginning in 2014. They project we won’t reach full employment until the end of 2017, almost five years from now.
• CBO estimates that the total lost economic output over the decade will be equal to the entire U.S. economic output for half of last year.

THE PRESIDENT:  Good afternoon, everybody.

I wanted to say a few words about the looming deadlines and decisions that we face on our budget and on our deficit — and these are decisions that will have real and lasting impacts on the strength and pace of our recovery.

Yesterday was the legal deadline for the President to submit his budget to Congress. Not only did he miss the deadline again this year, but his team has given no indication of when they will meet this legal requirement.

In these remarks the President proposes to delay immediate spending cuts and substitute a combination of (future, I think) spending cuts and tax increases. Even if you believe this will have a “real” effect on our recovery, it won’t have a “lasting impact” on it. A temporary loosening of fiscal policy would, at most, temporarily goose economic growth. That’s not “lasting.”

THE PRESIDENT: Economists and business leaders from across the spectrum have said that our economy is poised for progress in 2013.  And we’ve seen signs of this progress over the last several weeks. Home prices continue to climb.  Car sales are at a five-year high.  Manufacturing has been strong.  And we’ve created more than six million jobs in the last 35 months.

And GDP was flat last quarter … and the unemployment rate ticked up last month. 6M / 35 = +171K jobs/month, which when unemployment is high is nothing to brag about. “Our economy is poised for progress” is what you say when you can’t say “our economy is growing now.”

THE PRESIDENT: But we’ve also seen the effects that political dysfunction can have on our economic progress.  The drawn-out process for resolving the fiscal cliff hurt consumer confidence.  The threat of massive automatic cuts have already started to affect business decisions.  So we’ve been reminded that while it’s critical for us to cut wasteful spending, we can’t just cut our way to prosperity.  Deep, indiscriminate cuts to things like education and training, energy and national security will cost us jobs, and it will slow down our recovery.  It’s not the right thing to do for the economy; it’s not the right thing for folks who are out there still looking for work.

He argues that the past drawn-out process caused uncertainty which hurt consumer confidence. He recently made a similar argument against a short-term debt limit extension. But eight paragraphs from now he proposes to delay the sequester, further “drawing out” that process, to allow time to substitute different spending cuts and tax increases for the sequester. By his own logic, his proposal should further hurt consumer confidence.

I’m not sure how to respond to his point that immediate government spending cuts cause economic harm, because he has no proposal to tell us what he wants instead. If he proposes to change the mix of deficit reduction (more tax increases and defense spending cuts, fewer nondefense spending cuts) but not the timing, then all he’s doing is shifting resources from the private to the public sector, and from one part of government to another. That’s going to have no short-term growth effect and will hurt long-term growth because the private sector is smaller.

If instead he wants to substitute future deficit reduction for that which is about to begin March 1, then he is, in effect, arguing that given a weak economy, our budget deficit this year ($845 B or 5.3% of GDP) isn’t big enough. This is a traditional Keynesian fiscal stimulus argument. But his problem is that the numbers are too small: the sequester will cut spending this calendar year by about $65 B. Even if you push all that deficit effect into future years, you’re not going to move the needle much on a $16 T economy.

The deep indiscriminate cuts to which he refers are the result of the sequester that his advisors proposed to Congress in July of 2011 and which he signed into law that August.

And he argues that cutting government spending now would harm the economy and “folks who are out there still looking for work,” but his solution means that government employees would be protected from job loss while those previously employed in the private sector had to suffer the pain of a weak labor market. That doesn’t seem fair.

THE PRESIDENT: And the good news is this doesn’t have to happen.  For all the drama and disagreements that we’ve had over the past few years, Democrats and Republicans have still been able to come together and cut the deficit by more than $2.5 trillion through a mix of spending cuts and higher rates on taxes for the wealthy.  A balanced approach has achieved more than $2.5 trillion in deficit reduction.  That’s more than halfway towards the $4 trillion in deficit reduction that economists and elected officials from both parties believe is required to stabilize our debt.  So we’ve made progress.  And I still believe that we can finish the job with a balanced mix of spending cuts and more tax reform.

He’s got a small verb tense problem and a large logic problem here. Policymakers have cut the deficit by less than $100 billion so far, and they have enacted policies which, if not unraveled by future laws, would result in another $2.4ish trillion in deficit reduction over the next nine years. But all these future savings are from cutting discretionary spending, which is what the President is (ambiguously) proposing to undo here. It seems a bit hypocritical to simultaneously claim credit for enacted future cuts in discretionary spending at the same time you propose to undo them. The President would have more credibility here if he were proposing specific spending cuts and tax increases to substitute for the spending cuts he wants to undo. But the only thing he is specific about is that he wants to undo or delay the impending spending cuts.

THE PRESIDENT: The proposals that I put forward during the fiscal cliff negotiations in discussions with Speaker Boehner and others are still very much on the table.  I just want to repeat:  The deals that I put forward, the balanced approach of spending cuts and entitlement reform and tax reform that I put forward are still on the table.

But what exactly are those proposals, and will the President propose them in his budget? If he is willing to use a chain-weighted CPI for COLAs and tax bracket indexation, will he propose it? If he is willing to raise the eligibility age for Medicare, will he propose it? If not, how do we know what he is actually proposing? By reading Bob Woodward’s book and background quotes from unnamed senior advisors in POLITICO? He has never told us what this deal is that he put forward, nor has he proposed it to anyone other than Speaker Boehner. If you think it’s good policy, Mr. President, then put it in your budget.

Also, the deal in December has to be modified, right, since a new law enacted $600+ B of current and future tax increases? So technically the deal the President put forward then at a minimum has to be updated to reflect the new law, right?

THE PRESIDENT: I’ve offered sensible reforms to Medicare and other entitlements, and my health care proposals achieve the same amount of savings by the beginning of the next decade as the reforms that have been proposed by the bipartisan Bowles-Simpson fiscal commission.  These reforms would reduce our government’s bill — (laughter.)  What’s up, cameraman?  (Laughter.)  Come on, guys.  (Laughter.)  They’re breaking my flow all the time.  (Laughter.)

He mentions only one of the Big 4 entitlements. He and his party slowed Medicare spending growth in 2010, but then they turned around and spent those savings on a new health entitlement. Now he proposes again slowing Medicare spending growth, but ignores the other three sources of medium-term spending growth: Social Security, Medicaid, and the new health subsidies from the Affordable Care Act.

THE PRESIDENT: These reforms would reduce our government’s bills by reducing the cost of health care, not shifting all those costs on to middle-class seniors, or the working poor, or children with disabilities, but nevertheless, achieving the kinds of savings that we’re looking for.

Translation: He’ll cut medical provider payments rather than raise copayments, deductibles, or premiums.

THE PRESIDENT: But in order to achieve the full $4 trillion in deficit reductions that is the stated goal of economists and our elected leaders, these modest reforms in our social insurance programs have to go hand-in-hand with a process of tax reform, so that the wealthiest individuals and corporations can’t take advantage of loopholes and deductions that aren’t available to most Americans.

Translation: I’m not touching the big entitlements unless Republicans raise taxes (again, more) at the same time.

I disagree that his proposals “achieve the kinds of savings we’re looking for,” and that “the full $4 trillion in deficit reduction” is the right target, given that his stated goal is only to get the deficit down to 3% of GDP for the next decade. We need more savings now to start reducing debt/GDP, and we need long-term spending cuts for when entitlement spending growth is otherwise projected to explode. We need much more than $4 trillion of deficit reduction over the next decade, and it’s incorrect to suggest that there is a consensus among elected leaders on that point.

The “loopholes and deductions that aren’t available to most Americans” language is new to me. I wonder what he means? Tax deductions have greater dollar value to a high-income taxpayer than to “most Americans,” but both taxpayers have these preferences “available to them.”

THE PRESIDENT: Leaders in both parties have already identified the need to get rid of these loopholes and deductions. There’s no reason why we should keep them at a time when we’re trying to cut down on our deficit.  And if we are going to close these loopholes, then there’s no reason we should use the savings that we obtain and turn around and spend that on new tax breaks for the wealthiest or for corporations.  If we’re serious about paying down the deficit, the savings we achieve from tax reform should be used to pay down the deficit, and potentially to make our businesses more competitive.

Here’s the President’s position, as best I can infer:

1. Raising taxes to offset tax cuts: Bad;
2. Raising taxes to reduce the deficit: Good but he’s not proposing it;
3. Raising taxes to increase spending: He’s proposing it while pretending he’s doing #2.

He argues that raising taxes to reduce future deficits is a good thing, but as I understand it he wants to raise taxes to pay for more government spending (by undoing the spending sequester). That’s quite different.

THE PRESIDENT: Now, I think this balanced mix of spending cuts and tax reform is the best way to finish the job of deficit reduction.  The overwhelming majority of the American people — Democrats and Republicans, as well as independents — have the same view.  And both the House and the Senate are working towards budget proposals that I hope reflect this balanced approach.  Having said that, I know that a full budget may not be finished before March 1st, and, unfortunately, that’s the date when a series of harmful automatic cuts to job-creating investments and defense spending — also known as the sequester — are scheduled to take effect.

I don’t blame the American people for agreeing with the President; he is personally popular and it is impossible for them to understand what he is proposing. He has never publicly described or proposed the deals he privately offered to Speaker Boehner. He hasn’t proposed a budget this year and doesn’t appear likely to do so soon. He calls government spending “investment,” tax increases “tax reforms,” and welfare payments “tax cuts.” He keeps shifting baselines against which he measures “balance” and he repeatedly conflates taxes and spending. I have been studying and working on fiscal policy for more than 15 years and I can barely understand what he’s saying. No wonder the American people are confused and frustrated.

He says, “I know that a full budget may not be finished before March 1st”:

• He missed the statutory deadline for proposing a budget and is creating further delays and uncertainty by not even announcing when he will propose a budget, complicating the jobs of both the House and Senate budget chairmen.
• The (often missed) deadline for a budget resolution conference report is April 15th.
• So it’s unfair to suggest that Congress is somehow failing by not finishing a full budget by the March 1 sequester deadline.

THE PRESIDENT: So if Congress can’t act immediately on a bigger package, if they can’t get a bigger package done by the time the sequester is scheduled to go into effect, then I believe that they should at least pass a smaller package of spending cuts and tax reforms that would delay the economically damaging effects of the sequester for a few more months until Congress finds a way to replace these cuts with a smarter solution.

Who in Congress is seriously discussing now “acting immediately on a bigger package?” Anyone? The Grand Bargain died on New Year’s Day with the enactment of a $600+ B tax increase. This is another straw man so that the President can repeatedly say “I’m for a big deal” while making no new concessions to get one done nor taking any steps to create an environment in which such a deal might happen. The “if” clause above is therefore trivially true. The President is saying Congress should replace or delay the sequester for a  few months but he offers no specific proposal to do so.

THE PRESIDENT: There is no reason that the jobs of thousands of Americans who work in national security or education or clean energy, not to mention the growth of the entire economy should be put in jeopardy just because folks in Washington couldn’t come together to eliminate a few special interest tax loopholes or government programs that we agree need some reform.

Yes, there is:  Because if you enact a law now that raises taxes now and promises to cut future spending, what is to say that those future spending cuts won’t again be delayed, just as the President is proposing to do now? Also, shifting resources from the private sector to the public sector (aka “tax-and-spend”) doesn’t increase economic growth, it stifles it.

And he’s exaggerates when he suggests that “the growth of the entire economy” is contingent on whether government spending is cut by four-tenths of a percent of GDP this year.

THE PRESIDENT: Congress is already working towards a budget that would permanently replace the sequester.  At the very least, we should give them the chance to come up with this budget instead of making indiscriminate cuts now that will cost us jobs and significantly slow down our recovery.

Are they? Maybe the Senate is. I’m not sure the House is looking to replace the sequester in their budget. Time will tell.

THE PRESIDENT: So let me just repeat:  Our economy right now is headed in the right direction and it will stay that way as long as there aren’t any more self-inflicted wounds coming out of Washington.  So let’s keep on chipping away at this problem together, as Democrats and Republicans, to give our workers and our businesses the support that they need to thrive in the weeks and months ahead.

Wouldn’t it be nice if he had said “let’s keep chipping away at this problem together, as Americans, …” rather than “as Democrats and Republicans”?

THE PRESIDENT: Thanks very much.  And I know that you’re going to have a whole bunch of other questions.  And that’s why I hired this guy, Jay Carney — (laughter) — to take those questions.

Thank you, everybody.

I have a question: Where is the President’s specific proposal? At 7:43 AM EST today POLITICO reported:

POLITICO: President Barack Obama will propose a package of short-term spending cuts and tax reforms in an effort to head off the looming sequester cuts Tuesday at 1:15 p.m., a White House official tells POLITICO.

What happened to the “package of short-term spending cuts and tax reforms?” It seems to have died between 7:43 AM and 1:15 PM when the President spoke.

(photo credit: White House photo by Pete Souza)