A Timid Budget Bodes Ill for Nation’s Finances

In the midst of the larger debate over the state of the nation’s public finances, the Obama administration presented its fiscal year 2012 budget proposal to Congress last week. Following three years during which federal outlays reached unprecedented levels, the new budget has been positioned as a step forward in addressing the serious fiscal imbalances that increasingly threaten the long-term prosperity of the United States.

But the budget fails in this regard, as it reins in the deficit to a sustainable level only temporarily, and even then only by making liberal assumptions about the strength of economic growth.

Rather than moving us decisively closer to fiscal sustainability, the budget plan as offered is woefully inadequate for the task of correcting the structural drivers of the federal deficit. Rather than addressing persistent and well-understood challenges relating to the structure of entitlements, it meets the demands of largely unchecked growth in Medicare, Medicaid and Social Security by curtailing discretionary expenses. We are robbing Peter to pay Paul.

The parties are clearly aware of the budget’s shortcomings and are seeking to negotiate politically sensitive issues in a private arena that affords a greater chance of bipartisan cooperation. Understanding that entitlement reform must be part of any permanent solution to the structural deficit, senators have taken up the task of negotiating possible alternatives.

Until Senate negotiations bear fruit–perhaps as soon as this week–the absence of clear direction and the budget’s observable shortcomings have contributed to a cacophonous debate over the budget’s minutiae that is most notable for the absence of concrete proposals for entitlement reform. This is unfortunate given that public sentiment has rarely been so conducive to meaningful reform as it is now.


What the Budget Offers

While not tackling the entitlements that are the principal drivers of the long-term structural deficit, particularly as they relate to health care, the budget proposal does seek to manage the non-security discretionary outlays that account for 12 percent of total spending in FY 2012. It also leverages an improving economy in projecting positive adjustments in revenues and outlays as compared to the period of fiscal crisis and recession.

For example, an improving labor market will reduce unemployment benefit costs and drive increases in tax receipts. As a result, the budget shows expenses on unemployment insurance benefits falling from $146 billion in FY 2010 to $93 billion in FY 2012.

Among the key measures included in the budget is $400 billion in savings relative to baseline, achieved by freezing non-security discretionary spending at 2010 enacted levels for the next five years. In addition to that broad measure, the budget calls for a two-year wage freeze for civil service employees and targeted spending cuts in defense and non-defense programs. Tax adjustments will limit itemized deductions for high-income households while also targeting programs such as Pell Grants and the tax treatment of firms in the energy sector.

Apart from its myriad spending reductions and freezes, the budget includes increasing funds for specific projects that are intended to increase employment while enhancing the productive capacity of the domestic infrastructure.

The budget describes these projects, which include a national high-speed rail system, as “… a historic investment in repairing, rebuilding, and modernizing our transportation infrastructure.”

Alongside specific projects for infrastructure investment and modernization, the budget also outlines a proposal for a National Infrastructure Bank that would channel low-cost funding to a more varied set of projects, requiring outlays of approximately $30 billion.


Questionable Growth Assumptions

The administration points out that its various proposals are designed to position “… the discretionary budget on a sustainable trajectory.” In considering the severity of proposed cuts to discretionary spending, policy makers are no doubt mindful of the economic impact as well as the political consequences.

In his New York Times column last week, Paul Krugman points out that “slashing spending while the economy is still deeply depressed is a recipe for slower economic growth, which means lower tax receipts.”

Evidence in support of Professor Krugman’s contention can be found just across the pond, where the British economy contracted in the fourth quarter, coinciding with a painful austerity program. While proponents of fiscal stimulus may point to the U.K. as an example of why we must move deliberately, there is little cause for worry about such a cutback-induced double dip in the U.S. As it stands, policy makers here have shown no signs of cutting spending with the resolve or sense of purpose that has been shown in Europe.

In marked contrast with the European experience, the budget’s underlying assumptions suggest that growth will accelerate in the face of curtailed discretionary spending. While cyclical improvements in the budget shortfall will follow from lower unemployment and an expanding tax base, the forecasts supporting the analysis are surprisingly sanguine. In particular, the budget assumes real G.D.P. growth (year-over-year) of 3.6 percent in 2012, 4.4 percent in 2013 and 4.3 percent in 2014.

Based on the most current data, the forecast from the Office of Management and Budget (OMB) seems implausible. In comparison, the nonpartisan Congressional Budget Office (CBO) projects that growth will be more subdued, reaching 3.1 percent in 2012 and 2013 and increasing to 3.5 percent in 2014. The Blue Chip consensus forecast is even more restrained, with growth in 2014 projected to reach just 2.8 percent.

If the CBO projection proves out, the deficit in 2014 will be more than $500 billion larger than stated in the administration’s budget proposal. A simple stress test of the budget assumptions-the likes of which the government might request of a bank-shows that the government’s program fails to pass muster.


Getting to the Root of the Problem

Correcting a history of fiscal mismanagement in which all parties share a measure of culpability precludes the assignment of blame, nor is it just about the legacy we leave for the next generation. The impact of our choices, and of the intractability of the entitlement debate, is observable in the here and now. The data offer a sobering reality in this regard.

According to the budget proposal itself, net interest on the debt will finally surpass non-security discretionary spending in 2014, doubling from present levels to $418 billion. Those are dollars that will not be spent on schools, roads or any other program, but instead will be used to service the accumulated debt.

Whichever side of the political spectrum we find ourselves, and irrespective of whether we are ideologically predisposed to an expansion of government programs or tax cuts, the consequences of our profligacy have grown out of proportion with our policy priorities. But should we choose to seize upon it, the opportunity to concede that entitlement reform must occur in earnest-and that cuts to discretionary spending are the result of our inaction rather than this budget’s success story-still awaits us along the path to sustainability.


Sam Chandan, Ph.D., is global chief economist of Real Capital Analytics and an adjunct professor at the Wharton School.

A Timid Budget Bodes Ill for Nation’s Finances