As the debt ceiling debate marches on, politicians are under more and more heat from bond investors and rating agencies to reach a deal that would avoid both a crippling default and a credit downgrade. The legal debt limit driving the deal has forced a conversation Washington has long managed to avoid, which, all in all, seems like a good thing. But in the heat of the moment, it’s worth wondering whether the deadline pressure, coupled with the desire to please constituents and credit raters, might be stoking some funny math.
As Democrats argue their case for more taxes and Republicans argue for bigger cuts, what everyone’s ultimately hoping is that we’ve got the growth to justify either one. But there’s a pretty good chance we don’t — not only because there are massive uncertainties ahead for the U.S. and global economies — but also because our official growth forecasts tend to suffer from wishful thinking. That’s the gist of a new study by Jeffrey Frankel for the National Bureau of Economic Research, which finds that the United States tends to over-estimate its budget forecasts by a whopping 3% of GDP over a three-year time horizon. 3%, as it happens, is the average size of the U.S. deficit. In other words, says Frankel, “on average [the U.S.] repeatedly forecast a dissappearance of their deficits that never came.”
The reason for the bias is simple. If the official forecast is optimistic, why take painful steps to cut spending or raise taxes? The administration’s Office of Management and Budget tends to inject more bias into its estimates than the more independent Congressional Budget Office and the Federal Reserve, the paper notes. But even the trustier CBO has proven to be delusional. A chart cranked out by FT‘s Alphaville shows that, in 2002, the CBO projected we’d be rolling in budget surpluses all the way through this year. Our debt-to-GDP, according to those projections, would by now be a piddly 10%.
The over-optimism doesn’t just show up in boom times. Frankel finds that wishful thinking gets worse in periods of uncertainty, whether the economy is flying high or in the dumps. In an unusually deep recession, for instance, it’s hard to tell how long the funk will last, and forecasters opt for scenarios that allow for bad news to melt away.
Meanwhile, the temptation to create rules to force fiscal discipline, it turns out, often ends up making the over-optimism worse.
It is not always the case that “tougher” constraints on fiscal policy increase effective budget discipline. Countries often violate their constraints. In an extreme setup, a rule that is too rigid – so rigid that official claims that it will be sustained are not credible — might even lead to looser fiscal outcomes than if a more moderate and flexible rule had been specified at the outset.
The debt ceiling, along with the spending caps and balanced budget rules being floated in Congressional proposals, fits that description. And the case of Europe is an example of why rules like those tend not to work. The countries in the EU that had to do the most to meet their deficit requirements of 3% (a demand set out in Europe’s Maastricht treaty) are the ones that suffered the most from biased budget forecasts.
So even if the debt ceiling produces the desired budget deal, as I’ve said before, there’s no guarantee that it will actually get the job done. And if credit rating agencies flag the deal as hot air, we’re in for an even bumpier ride.