Tuesday, March 15, 2011

BWR on growth and the debt.

More great analysis courtesy of Vlad Signorelli at Bretton Woods Research, in partnership with Louis Woodhill. The chart below deserves wide circulation.

Notes on the Growth Scenario
Mar 14 2011

Given the stir our recommended reading "Paul Ryan Is Wrong" created among clients last week, we asked Forbes columnist and Club for Growth Leadership Council member, Louis Woodhill, to elaborate on the growth case in relation to the deficit and public debt from a technical perspective.

Below Louis explains how the CBO's doomsday Alternate Fiscal Scenario emerged. It was unveiled in June 2010 and has become the dominant projection for various studies on the subject, including President Obama's "Debt and Deficit Commission" and is routinely cited by Congressman Paul Ryan. It assumes an average annual growth rate of 2.16%. Woodhill, who is also an engineer and successful software entrepreneur, has done a yeoman's job working through the numbers and constructing a budget model that closely approximates the inputs and outputs of the CBO case. This allows different scenarios to be explored such as if the U.S. economy were to grow close to its historic norm of 3.5%.

His model in printable excel format is available upon request.

-Bretton Woods Research

Notes on the Federal Deficit, Debt & Faster Growth
March 12, 2011

Concern about Federal deficits and the mounting Federal debt escalated noticeably after the Congressional Budget Office (CBO) released its “Long Term Budget Outlook” (LTBO) on June 30, 2010. One of the cases they presented, their “Alternate Fiscal Scenario” (AFS), became widely cited in various studies and articles. The AFS was the basis for the work done by President Obama’s “Debt and Deficit Commission”, headed by Alan Simpson and Erskine Bowles.

The CBO's AFS predicted financial doom, with “Federal debt held by the public” rising rapidly and steadily until it reached an incredible (and unsustainable) 947% of GDP in 2084, which was the end of the CBO’s forecast period. As bad as this number was, it did not include the ongoing unfunded liabilities of Social Security and Medicare.

What was striking about that budget outlook is that it was based upon a single, very pessimistic forecast of economic growth, averaging 2.16% over the period. No cases were run on the sensitivity of the results to higher rates of economic growth. This was curious, since economic growth is the variable that has by far the largest impact on Federal finances.

On July 11, 2010, Erskine Bowles publicly asserted, "We can't grow our way out of this. We could have decades of double-digit growth and not grow our way out of this enormous debt problem." This statement prompted me to write a piece for RealClearMarkets entitled, “The Conspiracy Against Economic Growth”.

My article was based upon a financial model that I constructed using the CBO's numbers. The latest version of this model has the filename “Growth vs Spending Cuts LRW V6 031111”. The model includes the same dollar amounts of non-interest Federal spending assumed by the CBO alternative fiscal scenario. The model makes it possible to examine the impact upon Federal debt held by the public of changes in four variables: 1) real GDP growth; 2) the Federal “tax take” (taxes as a % of GDP); 3) real interest rates; and, 4) non-interest spending.

As expected, if the assumed GDP growth rate is increased to levels that are historically “normal” for the U.S. (3.5%), the debt/deficit problem goes away, whether or not spending is cut.

To illustrate this point, the following is a chart of the public debt as percentage of GDP for the next 73 years with a 2.16% growth rate as well as with an annual growth rate of 3.5%.

It is important to note that the model does not reflect the fact that higher economic growth would produce higher wages, which would eventually lead to higher Social Security costs. However, it also does not take into account the fact that higher economic growth would lead to lower costs for various “safety net” programs, like unemployment insurance, food stamps, and Medicaid.

Congressman Paul Ryan stated earlier this week on Kudlow & Company that faster economic growth cannot solve the financial problems of Social Security. This does not make sense. As a thought experiment, imagine that we woke up tomorrow and real wages had doubled. This would cause Social Security tax revenues to immediately nearly double, but outlays would rise only with a considerable lag. From this example, it is obvious that there has to be some rate of economic growth that would solve the problems of Social Security.

-Louis R. Woodhill


  1. The analysis is flawed because the CBO and Woodhill both use the absurd convention in their models of holding interest rates constant for 20 years. It does not take a genius 'modler' to consider that flexing growth might also mean you should should flex interest rate at the same time. Another problem is that the model is based on the GDP which is a spending metric and not a 'real growth' metric. The Woodhil treatment merely accepts a terribly flawed model wrong more by its matrix and structure than by any single variable, and he manipulates a single variable. We go from junk in to junk out to more junk in and junk out.

  2. Here's the point -- Woodhill takes the CBO's model (which has it flaws and limitations) and changes one variable, GDP growth, to get a much brighter outcome. This is an important contribution to the discussion, because it allows people to think about what kind of policies can enhance production and increase revenues, rather than simply keep the policy discussion focused on cutting entitlements or even worse, raising capital gains or personal income taxes to pay for them.

    BTW - I'm not sure where you are headed with your reference to changes in growth and "flexing" interest rates and how that might be modeled. I see no hard and fast rule sets for that, given the historical data. For instance, interest rates on average declined between 2003 & 2007, when GDP growth averaged about 3.2%. And during the 1983-1988 expansion, when GDP averaged 4.43%, interest rates also declined. Of course, interest rates can also decline during recessions as we know by our recent 2008-2009 experience.