Why Any Debt-to-GDP Projection for the U.S. Is Too Low

The CBO (Congressional Budget Office) will publish an updated Budget and Economic Outlook sometime next week that, along with all the budget changes stemming from the fiscal cliff deal arrived at earlier in the month, might also include changes to the other part of the debt-to-GDP calculations - economic growth.

Per the CBO’s latest report from last summer, it seems that government economists have been rather optimistic about the nation’s growth track (see Debt-to-GDP and Misdiagnosing a Bubble Economy’s Ills from last week for reasons why) and all too many people seem to forget that the denominator in the debt-to-GDP equation is as important as the numerator, perhaps more important.

Upon closer inspection, it would appear that, absent another massive financial bubble of some kind, the CBO’s estimates of economic growth over the next decade are far too high which, by extension, would imply that the current debt-to-GDP estimates are far too low.

Of course, maybe that’s what everyone’s banking on - another massive bubble to (temporarily) spur growth.

Be that as it may, it’s worth looking at how the CBO’s economic growth forecast - some 4.3 percent from 2014 to 2017 and 2.4 percent from 2018 to 2022 - stacks up against the historical record and that’s exactly what’s shown below using five year time spans.

While the later years look pretty reasonable, the four-year stretch that begins in 2014 sort of sticks out like a sore thumb in the graphic above - and not just because it’s in red.

To achieve this would be quite a feat, something that hasn’t happened in any five-year period since the late-1960s when “guns and butter” spending were giving the U.S. economy a real boost, that is, prior to playing a key role in ending the Bretton Woods monetary system a few years later.

The five-year periods above were chosen somewhat arbitrarily and, as you may have guessed, there were a few four-year periods where growth exceeded 4.3 percent, so, this is not without precedent since the 1960s.

The economy expanded at an average annual rate of 4.7 percent in the four years ending in 1979 as the commodities boom came to an end. Then, ending in 1986 and 1987, the economy expanded at an average rate of 4.8 percent and 4.5 percent, respectively, leading up to the 1987 stock market crash. More recently, there were 4.4 percent and 4.5 percent four-year average expansions that ended in 1999 and 2000 that coincided with the bursting of the internet stock bubble.

It looks like what the CBO is really forecasting is another big asset bubble.

What the CBO has forecast for 2014 to 2017 isn’t impossible, but it’s highly unlikely that it will come to pass, particularly when considering that, save for the burgeoning business of student loans, American consumers still haven’t recovered their appetite for piling up new debt, one of the most important factors in driving economic expansions in recent decades.

Lower economic growth means a lower-than-expected level of GDP in the out-years which also means that whatever debt-to-GDP numbers are being calculated using the current CBO growth forecast are on the optimistic side, if not an outright fantasy - unless we get another big asset bubble.

Here’s another way to look at the same data - this time divided up by decades.

When combining the 2014-2017 CBO growth estimate with the one for 2018-2022, you get an overall annual growth rate of about 3.1 percent and it’s not hard to see why so many economists might think that this is achievable - it’s been done before from the 1970s to the 1990s.

It’s as if the slow growth in the 2000s was an aberration - in many ways similar to what happened in the 1930s - and, starting next year, the nation is supposed to somehow return to the rates of growth that accompanied the biggest expansion of public and private sector debt the world has ever seen.

Unfortunately, this is not likely to happen, although another monstrous asset bubble could make it appear that it is for a year or two before an even bigger financial crisis develops. 

Other factors that makes returning to the 1970s-1990s growth rate nearly impossible is that the population isn’t growing as fast as it was back then and women are no longer entering the workforce as they did in the second half of the 20th century. One of the dirty little secrets about economic growth is that a good portion of it comes simply from population growth that, in the U.S., has declined from 1.7 percent per year in the 1950s to less than 1 percent in the decade just concluded.

The female labor force participation rate nearly doubled from 1950 to 2000 in an almost linear fashion but, since then, it’s been flat.

The U.S. economy would have to do substantially better in the decade ahead than it did from 1970 to 2000 to equal that period’s growth while compensating for these factors - the equivalent of somewhere between 3.5 percent and 4.0 percent growth which sounds pretty far-fetched.

What’s the impact of lower growth than the CBO forecast on the nation’s debt-to-GDP ratio?

That’s a good question, but not one that will be answered here today.

My guess is that, at some point, the U.S. debt-to-GDP ratio will prove to be significantly higher than it is currently being calculated after a more realistic forecast for economic growth is provided - one that is closer to our “new normal” of about two percent growth, not three or four percent.