budget deficits nearly always come in below official projections during what are usually an economic expansion's early, high-growth years. And for Team Bush, the shortfall in 2005 should prove a repeat of 2004 in this regard. The President's official economic projections released Dec. 17 leave substantial room for another year of outperformance, both for the federal budget balance and overall U.S. economic growth.
Take a look at the table below, which shows the newly issued economic assumptions for 2005, prepared jointly by the Office of Management & Budget (OMB), the President's Council of Economic Advisers, and the Treasury Dept., vs. both Action Economics' current forecasts and the prior Congressional Budget Office (CBO) and OMB estimates for the budget deficits and the economy.
Budget deficit ($ bil.)
Nominal GDP (Q4/Q4)
Real GDP (Q4/Q4)
GDP Chain Price (Infl.) (Q4/Q4)
Action Econ. est,
UNDERSHOOTING TARGETS. The table shows the OMB keeping its year-over-year estimate for fourth-quarter 2005 real GDP -- i.e., as adjusted for inflation -- of 3.5% from its July report. This number, as well as the CBO's 3.6% forecast in September, is well below Action Economics' 4.3% estimate.
The OMB has also lowballed the 2005 chain-price inflation forecast (as measured by what consumers and businesses actually pay for goods and services) at 1.9%. That's what we believe the OMB did in July with its 2.1% figure, and certainly what the CBO seemed to do with its 1.6% September estimate. We project a 2.5% chain-price gain for 2005, and we see our estimate comfortably in line with the trajectories in the consumer and producer price indexes through November.
The upshot: The official (unadjusted for inflation) GDP estimate for 2005 is 5.5% -- well below our own 7% forecast. Even the 2004 figures undershoot what we expect. Given that the data for the prior three quarters are already available, it appears that the OMB is assuming a 3.8% real GDP gain in the fourth quarter, with a 2% chain-price advance, which would leave about a 5.9% nominal GDP increase for the year.
For these three numbers, the Action Economics forecasts are all higher, at 4.5%, 2.2%, and 6.8%, respectively. If our estimates are right for just this one quarter, GDP will enter the new year at a higher level than the government agencies assume -- and with a firmer growth trajectory that will raise 2005 prospects.
UPSIDE RISK. To be fair to the official forecasts, the real GDP assumptions used for both 2004 and 2005 are consistent with economists' current consensus view. The BusinessWeek survey of 2005 forecasts, released at the same time as the OMB estimates, contained the same 3.5% real GDP estimate for 2005. Our own surveys reveal that economists are comfortable with a 3.8% fourth-quarter GDP growth assumption, even though it's below our estimate.
Still, we think these figures and the inflation estimates could go wind up higher, leaving particular upside possibilities for nominal GDP. Indeed, we would argue the market is already discounting stronger growth and inflation estimates than the economists' median numbers. Apparently, investors perceive added risk from the falling dollar and oil prices on U.S. inflation and may well think the U.S. economy's strong close for 2004 will give considerable upside lift to GDP, at least in the first quarter.
Of course, we wouldn't expect the conservative OMB or CBO to share our aggressive 7% nominal GDP growth forecast for 2005, or to adopt "alarming" inflation estimates for the new year. That would be politically awkward. But the combination of cautiousness with both real GDP and price estimates side by side leaves a 5.5% nominal GDP growth estimate that we think undershoots a reasonable assessment.
MISTAKES MATTER. Should investors care if the government number-crunchers are wrong? Yes. Forecast discrepancies in the official projections for nominal GDP matter because they're critical in determining the likely error in the official federal budget-deficit projections markets use to assess the condition of the government's balance sheets. Government receipts are highly sensitive to the nominal GDP growth path, so small GDP errors can mean big deficit-projection blunders.
For example, at the start of this year, market estimates for the fiscal 2004 budget deficit danced around the $600 billion mark, while the OMB cautiously projected a $521 billion gap. The actual deficit for the year of $413 billion came in under the OMB estimate by $108 billion and beat many market estimates by closer to $200 billion. How could they be so far off the mark? The reason for the huge forecast errors in 2004 is that nominal GDP grew during the year by 6.5%, vs. a 5.2% assumption held by many forecasters. What a difference 1.3 percentage points in GDP growth can make!
The error we now project for the official White House 2005 GDP forecast on a nominal basis is roughly as big as that in 2004. This raises the specter of a similar forecast discrepancy for the budget deficit of $100 billion to $200 billion. We currently expect the OMB and CBO official estimates of the 2005 fiscal deficit at the start of this year to lie in the neighborhood of $350 billion. An error similar to last year would literally cut this gap in half.
NOT TOO GLOOMY. Such a drop would be even more significant than it sounds, given that the U.S. budget balance has historically almost always been in deficit. As such, the comparison benchmark of a "balanced budget" -- intuitive for most people -- is a notion that's hard to apply to Washington. And, for purposes of international comparisons, the U.S. state and local government data have to be added to the federal figures for measurement of balance in the so-called U.S. government sector, and these lower levels of government should move back toward the $50 billion surpluses of the 1998-2000 period by 2006.
Indeed, the U.S. federal government has historically run a deficit of 2.1% of GDP since 1962, and this would be exactly the ratio in 2005 if the federal deficit were to fall to $263 billion. This ratio translates to an overall state and federal government deficit of around 1.5% of GDP, which is quite small by international standards. So here's another instance in which a GDP forecast error can make a huge difference.
That said, our own budget-deficit assumption for fiscal 2005 is $325 billion, which obviously implies a much smaller forecast error this year than might be drawn from the nominal GDP numbers alone. Our more cautious estimate of the federal budget forecast error by the OMB and CBO reflects the assumption that government spending will exceed official estimates, and that tax revenue will come in below model estimates.
The potential for a big GDP forecast error in 2005, however, reveals how risky it is to assume huge U.S. budget deficits for the foreseeable future. The federal government certainly faces some important financing issues for Social Security and Medicare over the coming decades, but the deficit's near-term outlook is not nearly as bad as the doom-and-gloom types would have us believe. Englund is chief economist for Action Economics