A comprehensive analysis by Goldman Sachs of the long-term US economic forecast discloses some rather unexpected pessimistic observations.
Last week the US Treasury closed the books on fiscal year (FY) 2009, a year that will go down as a gamechanger in modern US budget history. According to estimates by the Congressional Budget Office (CBO), the Treasury will report next week that the FY 2009 deficit was just over $1.4 trillion (trn). This is more than triple the FY 2008 shortfall and, at 9.9% of GDP, by far the largest relative to the size of the economy since World War II. Both revenues and outlays reached extremes not seen in more than 50 years (15% and 25% of GDP, respectively).
As we have pointed out, big financial firms spinning the current situation positively is not surprising. Just compare the hilarious recent commentary by BofA/ML's David Bianco who needs no Nitric Oxide stimulation after observing the DJIA for a full day. Yet even Goldman, which is not only always spot on with their BLS prerelease data, but is as big a part of the system as any other TBTF institutions, had some disturbing observations this time around.
The good news is that prospects looked worse earlier in the year, when we and the government agencies expected large outlays for stabilization of the financial
system to push the deficit to nearly $1.9trn. Restating the budget figures to include the net present value of the subsidy rendered by the federal takeover of the government-sponsored enterprises (GSEs) to conform to CBO?s accounting treatment of these transactions, the FY 2009 deficit appears to be almost $1.6trn. (The Treasury counts only the cash outlays arising from these transactions.) This is right in line with the latest estimates provided in late August by both the CBO and the Office of Management and Budget (OMB), and it is much better than our late-July estimate of $1.725trn.
The bad news is that the underlying fiscal imbalance is apt to widen further as the economy struggles to recover from the deepest recession in more than 70 years. By our reckoning, the combination of virtual stagnation in federal revenue, ongoing growth in mandatory outlays, a step-up in spending under the American Recovery and Reinvestment Act (ARRA), and a modest dose of additional stimulus will keep th
deficit at about $1.6trn in FY 2010 despite a large drop in financial stabilization outlays. On the revenue side of the ledger, our expectation of almost no change in FY 2010 (+0.6%) contrasts sharply with the latest CBO and OMB estimates, which show increases of 7.6% and 9.2%, respectively, as of late August.
Yet the biggest red flags even to Goldman are, not surprisingly, on the far side of the projection period:
The Longer-Term Outlook Worsens…
Beyond the new fiscal year that has just begun, the budget outlook is unusually uncertain, but it appears on balance to be worse than we previously thought. The deficit should start to shrink in FY 2011, and we have penciled in a modest reduction, to $1.35trn, for that year. But the uncertainty is higher than normal at this relatively close range for two reasons. First, a lot hinges on big policy decisions yet to be made, notably on healthcare reform and on tax cuts enacted in 2001 and 2003, which are due to expire at the end of 2010. Although the aim on healthcare is budget neutrality, this will be scored over the ten-year planning period; in some versions, it reduces the deficit in the early years. On the tax cuts, the main question is what makes the list of extendable versus expendable provisions; we have assumed that the extensions will favor lower- and middle-income taxpayers, adding the ?Making Work Pay? tax credit to the ones likely to survive.
The second source of uncertainty is the pace of economic recovery. It may still be tentative if past experience with financial crises is indicative. If so, the deficit may remain stubbornly high as well.
Over the full ten-year period, we now see the deficit cumulating to $10½trn, up from $9trn previously. In part, this reflects the revenue weakness discussed above for FY 2010, which is somewhat worse than we previously thought; with the economy expected to recover only gradually, the path of revenue is lower over most of the period. We have also recalibrated our adjustments to the CBO baseline estimates for income support programs. And, of course, these changes trigger increases in net interest expense. As a result, our projections now show the deficit dipping to only about 4½% in FY 2015, after which it rises to 5½% by FY 2019, as shown in Exhibit 4, about 1 point higher than before.
The unsustainability of this situation is evident in our projections for the primary balance, which excludes net interest expense. If this balance is in deficit, then
debt service will tend to escalate relative to GDP (unless GDP growth exceeds the level of interest rates, in which case a small primary deficit is sustainable). On this metric, our budget projections continue to show an unsustainable situation, with the primary deficit still converging to 2% of GDP but more slowly than we previously thought, as shown in Exhibit 5.
And here is a stunning observation that may have multiple layers of additional meaning to it.
On a moment?s reflection, it should be evident that this long-term budget projection is untenable.
And McKelvey and Hatzius continue:
While the US political system is hardly conducive to the assertion or maintenance of fiscal discipline, it is not impervious to the implications of a large and sustained fiscal imbalance either. In 1990, for example, the prospect of a deficit persistently in the vicinity of 5% of GDP led the elder President Bush to renege on his famous ?read my lips, no new taxes? pledge; at the same time, the Congress installed the pay-as-you go (PAYGO) framework that was widely credited with getting the budget into surplus by the end of that decade. More recently, this year?s surge in the deficit, to twice the 1990 level relative to GDP, has spawned genuine resistance to additional fiscal stimulus despite economic weakness. Under these circumstances, the notion that a 5% deficit is now the best that can be hoped for would likely set corrective measures in motion, at least if lawmakers believe that this is the path on which the budget is headed.
Goldman is so confused by its model output that it has decided to basically ignore it as it literally makes no sense from an economic viability and sustainability perspective! The only way to deal with the insanity out of D.C. is to shove one's head deep in the sand.
In fact, for this reason we do not see our long-term budget projection as a realistic forecast of what will happen, especially in the out years. Instead, we regard it as an alternative baseline to the one presented by the CBO, based on an economic view and a set of policy assumptions that we think are more realistic. Particularly with respect to policy, the CBO baseline is constrained to assume that current laws remain as they are. We, on the other hand, have the flexibility to choose which pending proposals are apt to occur and which are not, leaning for the most part on the CBO?s calculations to construct an alternative profile of how these choices will influence the budget balance.
Many words to describe what essentially is an impossible to maintain status quo. Yet hoping for change against the "change you can believe in" may be a foolish approach, even for someone as embedded in the system as Goldman.
On the surface, it may seem that the long-term budget imbalance we project results from policy choices yet to be made. This is suggested by the fact that the primary balance in the CBO baseline reaches zero during the second half of the 10-year horizon, as also shown in Exhibit 5. However, the CBO?s primary balance also depends on economic assumptions that, in our view, are overly optimistic, especially when combined with the policy assumptions. For example, it is quite unlikely that real GDP would grow 3.5% in 2011 and 5% in 2012, as the agency now assumes, in the wake of a decision to allow all of the 2001/2003tax cuts to expire, which the agency also must assume.
Therein lies the rub for today?s policymakers. The current imperative is to promote economic recovery, which requires measures (e.g., tax cut extensions) that will endanger the longer-term balance the CBO now projects. Yet without the tax cut extensions, or some other stimulus, the economy and the budget will suffer some damage anyway. At the same time, the prospect of a persistent primary deficit, whether it is due to a weak economy or to efforts to combat the weakness, underscores the need for policymakers to shift their focus nimbly to deficit reduction ?aka fiscal restraint ?whenever the economy strengthens to the point that it can tolerate the restraint.
Also for those curious how Goldman models its economic recovery process, here are their 6 core verticals, which lead the firm to conclude that an imminent decline in GDP is more than warranted shortly after the stimulus benefits evaporate sometime this quarter.
- We expect real GDP to rise at a 3% annual rate during the second half of 2009. The strength comes from three factors: (a) a swing in the inventory cycle toward significantly less liquidation, (b) federal fiscal stimulus, which should have its largest effects on quarterly growth rates during this period, and (c) a near-term rebound in home building from extremely depressed levels.
- However, recovery in 2010 is apt to be more anemic. The growth contributions from inventories and federal stimulus, currently about 4 percentage points at an annual rate in combination, will peter out by the second half of 2010. Meanwhile, the US economy faces several structural headwinds. Among them: (a) efforts by households to boost saving out of current income, aggravated by (b) weakness in labor income, reflecting the impact of high unemployment on wages and employers? reluctance to rehire aggressively, (c) fiscal drag from the state and local sector, (d) large overhangs of vacant homes and unused industrial capacity, which limit the potential for major improvements in private-sector investment, and (e) limited credit availability from a financial sector that is still on the mend. As a result, we expect growth to slow to an annual rate of 2% in the first half of 2010 and 1½% in the second half.
- The unemployment rate should continue to drift up, to about 10½% by year-end 2010. We think the ?jobless recovery? pattern of the 1991-1992 and 2001-2003 economic recoveries provides a better template for corporate hiring decisions over the next year or
two than the more robust payroll rebounds of earlier cycles. If this judgment is right, then net hiring will not absorb all of the influx into the labor force that is apt to occur during this period, in which case the cyclical peak in unemployment will again lag far
behind the bottom in real GDP.
- Inflation is not a significant threat, at least for the next few years. Although highly expansionary fiscal and monetary policies have caused many market participants to worry about inflation, these concerns miss the point that the policies have been undertaken
to combat a large and growing gap between actual and potential output. Under any reasonable economic scenario, the aggregate US output gap will be huge? currently about 8% of GDP and potentially as large as 10% ?and thus require years of above-trend growth to eliminate. Given this prospect, we expect year-to-year inflation in the core index of consumer prices?now at 1½%?to approach zero in late 2010.
- Monetary tightening is highly unlikely before the end of 2010. The outlook for Fed policy hinges on how strong the incipient recovery will be, and what the strength of that recovery means for inflation. We think most members of the Federal Open Market Committee (FOMC) will be reluctant to raise the funds rate target?even from its near-zero current setting?until they have some confidence that the unemployment rate has reached its cyclical peak or will do so shortly. This is especially true if our outlook for further disinflation is right. Accordingly, we see the FOMC?s strong commitment to low interest rates as expressed in its most recent policy statement as consistent with our outlook for stability in the funds rate through year-end 2010.
- Treasury yields should come down further. The Treasury yield curve has moved a long way towards our forecast, although in our view it still builds in too much Fed tightening next year. We expect 10-year note yields to continue their slide towards 3% over the next few months as final demand remains sluggish and disinflation continues. We also remain convinced that the increase in Treasury supply is less important for bond yields than many investors believe, for two reasons. First, increased saving by households and businesses creates a potential demand for Treasury securities as well as less competition for lenders? funds; flow of funds data and bank balance sheet reports confirm that the domestic private sector is increasing its allocation to Treasury securities. Second, the Treasury?s auction schedule for coupon securities is now more than adequate to meet funding needs over the next few years; as this becomes evident, concerns about further increases in auction sizes should abate.
While definitely squeezing some optimism out of the data, the schizophrenic undertone is definitely present: even Goldman, while seeing contained disinflation, as expected in keeping with the Fed script (or is that disdeflation?), has problems reconciling what is an untenable economic forecast based on conservative assumptions. How hope and reality will reconcile, nobody at this point is willing to discuss. And yet, at some point over the next decade, the worlds of imaginary optimism and pragmatic realism, will not only collide, but when one throws in the singularity that is the Social Security funding conundrum, and it is easy to see how the entire American model unravels in the not too distant future, even as we currently ride on the wave of transient hope brought to your courtesy of yet another TV appearance of the current administration.