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CBO 'Admits' Assumption That US Never Falls Into Recession Again Is Wrong

Tyler Durden's picture




 

Submitted by F.F. Wiley of Cyniconomics blog,

From budget projections released by the Congressional Budget Office (CBO) last week:

CBO now expects that output will fall slightly short of its potential, on average, even after the economy has largely recovered from the recent economic downturn.

Translation:

We’ve thrown in the towel on our long-time assumption that the economy never again falls into recession.

Shocker: the business cycle lives!

Not only did the CBO acknowledge the cycle, which we suggested might be a good idea here, here, here and here, but they built in recession effects using an approach we recommended.

We grossed up the CBO’s projections partly with an estimate of the average effects of automatic stabilizers. Lo and behold, Appendix E of the new report links budget projections to the average effects of automatic stabilizers.

What’s more, the CBO slashed its figures for potential output. The two changes together added over $1 trillion to projected debt in 2024.

We’ll be presumptuous and pretend that someone at the CBO read our research before implementing the new approach. Our blog may not be the main reason (or even part of the reason) for the change, but please don’t burst our bubble. Let’s say we’re 99% responsible for the CBO’s discovery of the business cycle.

We’ll even give our mole in the Ford House a name: “Jefferson Smith,” after the Jimmy Stewart character in “Mr. Smith Goes to Washington.” As you’ll guess if you’ve seen the movie, we’re assuming Mr. Smith is earnest, hard-working and wants to do well by the taxpayer.

Even more importantly, he wants us to acknowledge the tentative steps toward reality in last week’s report.

So, geeky bloggers full of unsolicited advice, you should be happy now, right?

Well, actually no.

Sadly, the extra $1+ trillion in debt is dwarfed by adjustments that still need to be made.

To show why the CBO remains way too optimistic, we’ll start with the new unemployment rate projections:

mr smith 1

The CBO’s long-term assumption of 5.5% is where the new recession “allowance” comes into play.  If not for the nod to the effects of automatic stabilizers, we’re told that the long-term rate would be about 0.25% lower.

Questions for Mr. Smith:

Why such a tiny change? Consider that the new long-term rate is still below the “Great Moderation” average from 1984 to 2007. Didn’t we learn that the economy’s performance over that period was illusory?

Next, we compare unemployment rate projections to the CBO’s assumptions for 3 month Treasury bills:

mr smith 2

Call us cynical, but it’s hard to imagine unemployment falling continuously through an interest rate jump to 3.7% in 2018. There are good reasons to expect a poor economy after interest rates rise, and especially after a trend that persists for several years. But don’t just take our word for it. To gauge the effects of large, sustained rate changes, we compared the change in interest rates for every 12 quarter period since 1945 to the change in the unemployment rate over the following year:

mr. smith 3

Here’s an interpretation of these results, lifted from “M.C. Escher and the Impossibility of the Establishment Economic View” (where we shared a similar analysis with the same conclusions):

While the results speak for themselves, I’d be remiss if I didn’t add qualifiers. For one, the sample sizes fall as you move from left to right across the charts. [See technical notes post.] Moreover, history doesn’t always foretell the future; this time could be different.

 

But the thing is: the data makes perfect sense. Higher interest rates have obvious effects on risk taking and debt service costs. It stands to reason that the economy won’t just sail through the large rate hikes needed to restore historic norms.

 

If anything, the charts likely understate the future effects of rising rates, because today’s debt levels are far higher than average historic levels. Any normalization must also include a wind-down of unconventional measures such as quantitative easing, which presents additional challenges.

More questions for Mr. Smith:

Considering the data in Chart 3, why does the CBO expect the unemployment rate to fall in 2019 after an assumed 3.4% interest rate jump over the prior three years? Why is it expected to fall in 2018 and 2020 after interest rate increases of 2.9% and 2.2% in the preceding three year periods?

Before you answer, though, understand our perspective on the rote explanation that projections beyond 2017 are based on “trends in the factors that underlie potential output” rather than “forecasts of cyclical movements in the economy.”

The CBO might as well write: “We only forecast ‘good’ cyclical movements – hence our long-standing prediction for a robust recovery – not ‘bad’ cyclical movements.”

The aggressive recovery assumption for the next four years just doesn’t jive with a meager recession allowance for the remainder of the projection. As shown in Charts 2 and 3, the worms crawl out when you look at the effects of interest rate changes, while Chart 1 shows that the long-term unemployment rate of 5.5% is too low.

Another question for Mr. Smith:

Why not balance the assumed recovery with the payback that invariably occurs after the economy heats up and interest rates rise?

Here’s how that might look:

mr smith 4

Here are the key assumptions behind the recession scenario:

  • From 2014 to 2017, it’s exactly the same as the CBO projection. (Hence, optimistic.)
  • The unemployment rate then jumps by 0.8% in 2018, 1.1% in 2019 and 0.8% in 2020, based on CBO interest rate projections and the history shown in Chart 3.
  • By 2024, the unemployment rate falls back to the post-1970 average of 6.4%. (For discussion of reasons to exclude the ‘50s and ‘60s from the average, see “7 Fallacies About the Lengths of Things.” Or, just poke around economics chatter for a Beveridge curve chart as well as the increasingly mainstream view that jobs market fundamentals are nothing like they were fifty years ago.)

Back to Mr. Smith:

Remember those “find the next number in this progression” problems from grade school? Well, let’s say you’re looking at the last 60 years of unemployment rates and using the same “find the next number” approach to guess the next 10 (as in Chart 4 above). Isn’t the chart’s green line a better answer than the red line?

In our last chart below, we show that the CBO’s budget outlook depends quite a lot on Mr. Smith’s answers to our questions. More precisely, the unemployment rate assumption has a huge effect on budget deficits:

mr smith 5

Notice that we split the red line in two to show the effects of the CBO’s recession allowance, with the dashed red line representing the old, “recessions don’t exist” approach. The recession allowance has little effect on its own. Although the CBO attributes over $1 trillion of extra deficits in this year’s report to changes in economic assumptions, other changes had greater impact.

The bigger issue is what might happen in a genuine recession. As shown by the green line, we’re projecting the recession scenario to add $2.2 trillion to total deficits through 2024. (Again, see our technical notes post for details.)  Needless to say, it’s a budget killer.

We could go on to show effects on public debt, but we’ll save those for our next update of “The Chart That Every Taxpayer Deserves To See,” which will show that other ways of making CBO projections more realistic have even larger effects than the recession scenario.

In the meantime, maybe the CBO would consider a staff screening of “Mr. Smith Goes to Washington,” and in particular, the Lincoln Memorial scene?

Here’s the setting: Stewart’s Mr. Smith takes a seat on the floor near Lincoln’s statue, dejected and determined to abandon his stand against Washington’s dishonest ways. The beautiful Jean Arthur, playing Smith’s assistant, lurks behind the columns. She finally walks over to him, sits down, and delivers the classic, Hollywood kick-in-the-butt speech.

She convinces him that he can’t quit, because he has “plain, decent, everyday, common rightness, and this country could use some of that… so could the whole cock-eyed world…”

“It’s a forty foot dive into a tub of water,” she says, “but I think you can do it.”

Could it be that the CBO’s Mr. Smith has the same “common rightness”? That he’ll make the “forty foot dive” to battle Washington’s resistance to inconvenient truths?

Those are our final questions, and we look forward to answers in future CBO reports.

 

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Thu, 02/13/2014 - 16:32 | 4433614 youngman
youngman's picture

They always say the CBO is not political...I say Bullshit...

Thu, 02/13/2014 - 16:36 | 4433625 y3maxx
y3maxx's picture

...All is fine friends, Obama to receive a Nobel Peace Prize for Economics.

Thu, 02/13/2014 - 16:37 | 4433629 Occams_Chainsaw
Occams_Chainsaw's picture

Don't give them ideas....

Thu, 02/13/2014 - 16:43 | 4433653 Say What Again
Say What Again's picture

A bit OT, but --

This has been one strange day in the "markets" 

Every index has experienced a Ramp-a-palooza even after the dismal job numbers and retail report.  But there is something I found that I fell is worth sharing with Team-ZH.  I track the Average Trade Size (ATS) on a number of assets, but today ES has had some strange behavior. 

Beginning at 13:50 the ATS for ES had a noticeable increase.  Then, at 14:37, the ATS abruptly went back to the daily average.  Note that, as of this writing, 13:50 was beginning of the Ramp-a-palooza, and ~14:15 was the end of the Ramp.

Not sure what to make of this, but the data is there for everyone to see.

Thu, 02/13/2014 - 16:46 | 4433656 NotApplicable
NotApplicable's picture

Tyler, you forgot to label this article "Thursday Humor."

Why anyone would spend more than two seconds looking at CBO "data" is beyond me.

Thu, 02/13/2014 - 17:17 | 4433811 zaphod
zaphod's picture

How the CBO can say short term rates are expected to rise to over 3% in 2015/16 is beyond me, when the market is clearly not pricing that in because everyone knows it will never happen.

The only way the government leaves ZIRP is to implement a NIRP environment.

Thu, 02/13/2014 - 18:09 | 4434030 max2205
max2205's picture

THEY KNOW NOTHING!

Thu, 02/13/2014 - 21:39 | 4434126 Boris Alatovkrap
Boris Alatovkrap's picture

They are know EVERYTHING, but they are sociopath psychotic lying bat turd, every last one. They are know and we are know, current Central Banking System, world wide, is end of game, no recovery. Only reset is war and debase to zero.

Reason is obvious when examine Ponzi scheme, but even if narrow look at current dilemma, duration mismatch can not be cure without utter collapse of fictional reserve banking system. You can sheer sheep, but once you are skin sheep, there is no more sheering. Fictional Reserve system is base on skim wealth from producer. In 2008 and forward, bankster is move aggressively to not just skim wealth, but utter destruction of wealth. Lend long and sell instrument is was become mechanism for skimming, but is all construct on debt, so bond is only fulfill with new debt. Now can borrow short at higher interest rate than is lend? Boris does not to think so...

... but what is Boris know?

Thu, 02/13/2014 - 16:37 | 4433634 Beam Me Up Scotty
Beam Me Up Scotty's picture

On paper, they can make any number up they want.  So yes, its possible to never see another recession, or depression.  On paper anyway.  They can pencil whip the numbers and with the full faith and credit of unlimited money supply, they can make anything be any number they want.

Thu, 02/13/2014 - 16:32 | 4433618 101 years and c...
101 years and counting's picture

"Shocker: the business cycle lives!"

not if janet has her way. 


Thu, 02/13/2014 - 16:35 | 4433623 skwid vacuous
skwid vacuous's picture

Turkey has been saved!!, and no debt ceiling!!... surprised not up more than 95 handles on this news...

Thu, 02/13/2014 - 16:34 | 4433626 Occams_Chainsaw
Occams_Chainsaw's picture

The more you ignore reality and keep pumping QE the better things will get.  Sigh......how do these morons manage to get jobs let alone not die from forgetting to breathe?

Thu, 02/13/2014 - 16:37 | 4433631 akarc
akarc's picture

“It’s a forty foot dive into a tub of water,” she says, “but I think you can do it.”

Huh, my ol lady told me the same thing?

Thu, 02/13/2014 - 16:36 | 4433636 Spastica Rex
Spastica Rex's picture

We must preserve our way of life - our blessed, non-negotiable, American way of life. Growth in everything (except unemployment), forever.

When do I get my flying car? My wife wants me ask when she gets her solid gold kitchen counter tops.

Thu, 02/13/2014 - 16:42 | 4433651 Occams_Chainsaw
Thu, 02/13/2014 - 16:42 | 4433646 Stuck on Zero
Stuck on Zero's picture

More rosy projects come if you assume pigs fly and water runs uphill.

 

Thu, 02/13/2014 - 16:43 | 4433654 Spungo
Spungo's picture

I once threw a ball in the air and it never came down. True story.

Thu, 02/13/2014 - 16:47 | 4433665 Bastiat
Bastiat's picture

Yeah and just wait and see what happens when interest rates go up and more of the US budget goes to interest payments while the economy contracts.   Taper and die.

Thu, 02/13/2014 - 16:50 | 4433671 TrustWho
TrustWho's picture

I feel for the CBO. The Fed's monetary repression is so large they are loading the pressure cooker like the Tsarnaev brothers did in Boston Marathon. Everyone knows, but no one in power can say, so everyone lies. When you have economic repression and the animal spirits are in the hospice, you produce shit for a forecast. All the humans in power use this shit to support their lies. They all nod their head, smile, slap each other on the back and tell each other how smart they are.

Fuck Bernanke and the deer in the headlight Yellen! 

Thu, 02/13/2014 - 16:54 | 4433688 Pairadimes
Pairadimes's picture

Correct me if I am wrong, but wouldn't we need to get out of the recession before we could fall back into it?

Thu, 02/13/2014 - 17:12 | 4433781 NOTaREALmerican
NOTaREALmerican's picture

Re:  but wouldn't we need to get out of the recession

There's only been a recession for the bottom 70% or so. 

The top 20% - those who matter - haven't had a recession yet. 

Thu, 02/13/2014 - 17:02 | 4433721 Ranger4564
Ranger4564's picture

I was just thinking of "It's a Wonderful Life" (being a banker). I will never look at the move the same way. Knowing what I know now, I would cheer the bank run and call the ending a sad ending because the fucking bank and banker survived. I now see this movie as a propaganda piece pro banking... not as a christmas story about some devoted schmuck.

Anyway, just a minor interlude as we watch the world deteriorate before the long weekend. I think I'll empty my bank account and buy more gold and silver with the remaining cash. I don't trust it to be there on Saturday if I leave it in the bank.

Thu, 02/13/2014 - 17:01 | 4433722 NOTaREALmerican
NOTaREALmerican's picture

This is rediculous!  

How can GDP ever fall again if the Fed does it's job and creates more prosperity?

None other than the famous Australian economist Dick Cheney said:  "Reagan proved deficits don't matter."    He is right.

If Reagan brought us amazing prosperity with a 600 ship navy, imagine what a 1200 ship navy could bring?

Do we really have enough Freeways?   Wouldn't having twice as many be twice as good?     And let's double the airports and double the dams too.  All of these programs, as the Australian economists know, brought amazing wealth to this nation from the 1950's through the 1970's.  Why did we stop?

Thu, 02/13/2014 - 17:53 | 4433934 ejmoosa
ejmoosa's picture

Static forecasting is worse than a stopped clock-it's never right.

 

For a while there in the 90's it appeared that the business subsectors were never all contracting at the same time.  Then we had the big build up for Y2k, and that delayed the cycles for many industries, as everyone sunk money into technology upgrades.  But that soon ended.

Since then, we have had the Fed trying to coax next year's buyers into the present, never asking what would replace the void where those buyers from the future were, since their needs had been satisfied.

You would think they had learned from watching the boom and bust cycles of the car industries, offering rebates this month to induce next month's buyers to come in and get a deal.

We never learn.

 

Thu, 02/13/2014 - 18:06 | 4434021 RaceToTheBottom
RaceToTheBottom's picture

Cue to a photo of a crashed supertanker rolling over and sliding under the waves for the last time....

Thu, 02/13/2014 - 18:20 | 4434064 Colonel Klink
Colonel Klink's picture

Hey CBO let me clue you in......FUCKING DUH!

Fri, 02/14/2014 - 07:49 | 4435884 Midnight Rider
Midnight Rider's picture

It all depends on how you define unemployment. If they keep changing the formula, they can make the number come out to whatever they want.

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