On May 14, as Washington officialdom was transfixed by the IRS scandal, the Congressional Budget Office announced that the budget deficit will shrink this fiscal year to $642 billion, or just 4 percent of gross domestic product. It’s the smallest deficit since 2008, and less than half 2009’s record $1.4 trillion shortfall. Since February, the CBO has cut $200 billion off its deficit projection for 2013 and $618 billion off its cumulative estimate for the next decade. Thanks to higher tax revenues and deep spending cuts, the deficit has been shrinking by about $42 billion a month for the past six months. The CBO projects that the deficit will fall to $342 billion by 2015, or only 2 percent of GDP.
Even so, the country’s improving finances haven’t lowered the din of partisan bickering over U.S. fiscal policy. Keynesian economists say that the deficit is narrowing too quickly, curtailing growth and threatening to derail an economy that grew a tepid 2.5 percent in the first quarter. Republican deficit hawks are unimpressed by the short-term reductions and want more cuts to head off exploding long-term debt driven by rising spending on Medicare, Medicaid, and Social Security.
“I must have missed the Kool-Aid,” says Douglas Holtz-Eakin, a former CBO director who served as John McCain’s chief economic adviser during the 2008 presidential campaign. To Holtz-Eakin, a deficit that’s 4 percent of GDP isn’t worth bragging about. Plus, the short-term reductions are mostly from technical revisions such as tax code changes and a $95 billion, one-time payment from Fannie Mae and Freddie Mac. The long-term situation is still scary, he says.
As millions of baby boomers retire, entitlement spending will start eating up government funds. Unless those programs are reined in, the CBO projects the budget deficit will start to rise again in 2016 and hit $895 billion by 2023. Also, today’s low interest rates, which allow the government to sell 10-year Treasury bonds below 2 percent, won’t last forever. The CBO projects that by 2023, annual interest payments on the country’s debt will nearly quadruple, to $823 billion. A new plan being floated by über-austerians Erskine Bowles and Alan Simpson, co-chairs of President Obama’s 2010 debt commission, calls for replacing the $85 billion in cuts from the sequester with $2.5 trillion in additional deficit reduction, including $220 billion in defense cuts and $585 billion in health-care savings through reforms to Medicare over the next 10 years.
Doves say that’s overkill given that the government is already shrinking faster than at any time since the post-World War II military demobilization. “The patient is checking out of the hospital, and the doctors are still planning surgery,” says Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities and Vice President Joe Biden’s former chief economist. Echoing a warning the International Monetary Fund issued last summer, Bernstein is concerned the deficit is contracting too fast from all the spending cuts enacted since 2010, including the $1 trillion in cuts President Obama agreed to in 2011. That’s stymied growth. In 8 of the last 10 quarters, the federal government has been a drag on the economy, subtracting 3.25 percentage points from GDP since the fourth quarter of 2010. “We’ve overfocused on the deficit,” Bernstein says. “It’s time to tackle the jobs crisis.”
According to the CBO, the economy is operating 6 percent below its potential, a difference of about $1 trillion this year. For every dollar the economy runs below its optimal level, the deficit rises by 37¢ due to cyclical factors such as lower tax receipts, says Andrew Fieldhouse, a budget policy analyst at the Economic Policy Institute. That’s what’s happened in Europe, where austerity has boosted debt-to-GDP ratios by about 5 percent. “Fiscal stimulus right now would decrease debt to GDP,” Fieldhouse says.
Not everyone thinks Medicare is doomed. Based on lower growth rates in health-care costs since 2010, the CBO cut its estimate for Medicare and Medicaid spending by $162 billion over the next decade. That could change, however, when Obamacare and potentially higher policy premiums go into full effect.
One thing the dip in the deficit has changed is the urgency to reach a deal on long-term debt reduction. Continued gridlock might not be so bad. “The last thing we want is some grand bargain,” says James Paulsen, chief investment strategist at Wells Capital Management. He argues that as long as the economy keeps growing, the deficit will continue to trend lower: “Who would you rather put in charge of fixing the country’s finances: Congress or the invisible hand of Adam Smith?”