Flawed Assumptions In Federal Budget Proposals

Today’s surge in unemployment to 8.1% — almost double that level when discouraged and part-time unemployed are included — threatens to gut the U.S. federal budget, rendering current administration proposals dead on arrival.

It underscores the argument I have put forward that the economic assumptions underlying the budget are seriously flawed, and that the debate now beginning regarding funding reallocations will be tantamount to shifting the deck chairs on the Titanic.

In our view, the flawed assumptions in the current budget planning are as follows:

Flawed assumption #1: Econometric GDP forecasting models are reliable tools to establish a basis for budgetary planning.

Why it’s flawed: GDP models are primarily designed to forecast gradual, continuous, linear changes in the economy. They are poorly equipped to handle sudden, discontinuous, structural changes, such as housing market collapses, mortgage meltdowns, major financial failures, credit market shutdowns, and stock market crashes.

Flawed assumption #2. The sharp declines in the U.S. economy recorded in the most recent six months are less important than the growth patterns established over a period of many years since the end of World War II.

Why it’s flawed: There is abundant empirical evidence that, in September of 2008, the bankruptcy of Lehman Brothers and the subsequent breakdown in global credit markets was a distinct break with the past, ending the six-decade era of growth since World War II, while marking the beginning of a new era of financial instability and economic contraction. Therefore, any GDP forecasting model must give lesser weight to the growth pattern of prior years and greater weight to the contraction in the economy since September ‘08. In addition, GDP forecasting models must also consider the patterns associated with the prior depression cycle.

Flawed assumption #3. The Great Depression was an anomaly that will not repeat itself and therefore is irrelevant to GDP forecasting in the modern era.

Why it’s flawed: Other than the 1930s Great Depression, there are no modern precedents for the current crisis. In the first three years of that cycle, GDP contracted as follows:

1930: -8.6 percent
1931: -6.4 percent
1932: -13.0 percent

These data points, no matter how extreme they may appear, must be incorporated into any reasonable model that seeks to forecast GDP for the period 2009-2011.

Flawed assumption #4. Thanks to a more assertive role by government, the current crisis cannot be — and will not be — as severe as the Great Depression.

Why it’s flawed: Economists and budget planners have not conducted the thorough comparisons between the two eras that would be needed to make such an assumption. Moreover, even a cursory comparison reveals the assumption may be incorrect: The 1930s depression was precipitated by a severe stock market decline in 1929; and the stock market decline experienced so far in this cycle is greater. The 1930s depression was aggravated by trade barriers and a failure of industrial nations to cooperate; and a similar pattern is beginning to repeat itself today. Most important, the 1930s depression was deepened and prolonged by financial collapses; and, despite government intervention, the collapses experienced to date in this cycle — including the failure of Bear Stearns, Lehman Brothers, Fannie and Freddie, Washington Mutual, Wachovia, AIG, Citigroup and others — are potentially more impactful than those of the 1930s.

Flawed assumption #5. With the help of the stimulus package, the typical GDP growth pattern of prior years will reassert itself, containing the recession to a meager 1.2 percent GDP contraction in 2009, and ending the recession with a 3.2 percent GDP expansion in 2010.

Why it’s flawed: For the fourth quarter of 2008, the government estimates that GDP contracted 6.2 percent, and due to a sharper-than-expected drop in construction spending, it may have to revise that figure to a 7 percent decline. For the current quarter, the just-released unemployment data (651,000 jobs lost in February plus 161,000 additional losses beyond those already reported in prior months) indicates that the economy is contracting at a similar pace. Therefore, to contain the economy’s contraction to a meager 1.2 percent in 2009 would require a dramatic second-half turnaround that’s nothing short of a miracle.

The fact that the financial crisis is probably worse in this cycle than at the equivalent period in the 1930s depression does not necessarily mean that the subsequent GDP declines will also be worse. But it does mean that the government’s GDP forecasts — the meager 1.2 percent decline in 2009 and the relatively robust 3.2 percent growth in 2010 — are a pipedream.

Flawed assumption #6. With a 1.2 percent GDP decline in 2009 and 3.2 percent growth in 2010, the budget deficit will be $1.75 trillion in the current fiscal year and will decline substantially in future years.

Why it’s flawed: For the reasons cited above, it is unreasonable and misleading to assume that economists can use their traditional tools to forecast GDP and the budget deficit in this environment. A common-sense approach to budgeting must assume a wide range of possible GDP scenarios, including a worst-case scenario similar to the 1930s. In that scenario, the federal budget deficit for 2009 and 2010 could be headed for $3 trillion each year, forcing the administration and Congress to focus instead on emergency measures to prevent a default by the U.S. Treasury and save the ship of state.

The most flawed assumption of all. Regardless of the deficit forecast or the specific allocation to particular projects, funding will be available no matter what.

Why it’s flawed: Funding of the federal deficit is contingent on three factors that are largely beyond the government’s power to control.

1. The credit and credibility of the borrower. Even in the absence of a depression, the credit and credibility of the U.S. government can be severely damaged when it implicitly or explicitly assumes the liability for trillions of dollars in bank deposits (as with Citigroup) and trillions more in insurance policies (as with AIG).

Weiss Research interest-rate specialist Mike Larson points out that, in an attempt to offset this rising risk, owners of U.S. government securities and other investors are already flocking to purchase insurance against a possible (even if unlikely) default by the U.S. Treasury, driving the premiums on U.S. Treasury credit default swaps to new highs. As a result, it now costs investors 98 basis points to buy protection against a Treasury default, up 14-fold from just 7 basis points in late 2007. (This translates into a premium cost of $9,800 per $1 million of U.S. debt, compared to only $700 previously.) As this premium cost becomes prohibitive, lenders will demand much higher yields on U.S. Treasuries or may begin to reduce their current holdings, making it prohibitively expensive — or virtually impossible — for the Treasury to refund its maturing debts.

2. The liquidity of lenders. U.S. debt is funded by individuals, domestic financial institutions and foreign governments. In a depression, each of these may suffer a decline in liquidity, may have reduced funds available for investment, or may have to cash out their holdings due to other, more pressing demands for their money.

3. The participation of government securities dealers. The U.S. government sells its debt securities much like an auto manufacturer sells its cars. General Motors, for example, rarely sells directly to the public. Instead, it uses a national network of dealers. These dealers buy the cars at auction, paying a wholesale price; hold the cars on their lots; and then mark up the price to sell them retail. Similarly, the U.S. government sells its securities at auction to a nationwide network of bond dealers who buy them wholesale, put them on their shelves, and mark them up for sale to the public.

Without the active, continuing participation of this network of private government-security dealers, the U.S. Treasury would be unable to roll over its maturing debts — let alone fund the new debts needed to finance a large deficit. These dealers, in turn, require relatively stable prices and fluid financing to continue to exercise that function. If markets are flooded with an unusually large supply of Treasuries, if there is severe damage to the credit and credibility of the U.S. government, or if U.S. and foreign bond buyers suffer a liquidity squeeze, the resulting sharp price declines in the market value of bond inventories held by dealers would threaten their capital, forcing them to withdraw from the Treasury auctions. Parallel disruptions in the interest-rate futures markets, where dealers seek to hedge their risk, would have a similar impact. The dealers would cease their bidding in Treasury auctions and U.S. government would find that deficit financing is impossible at any price.

This is precisely what occurred in early 1980, forcing President Carter and Fed Chairman Paul Volcker to impose draconian measures, including credit controls, to restore faith in the U.S. government securities markets. It can certainly happen again in the current era of financial collapses, surging premiums on U.S. Treasury credit default swaps and trillion-dollar deficits. And it could force the U.S. government to take emergency measures, such as massive budget cuts that could render the proposed budget cuts irrelevant.