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Congressional Budget Office Is Pessimistic About the Economy

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Written by Dean Baker   
Tuesday, 05 February 2013 20:51

The Congressional Budget Office (CBO) came out with its new projections for the budget today. There are not many surprises. It projects somewhat slower health care cost growth in recognition of the recent trend in the sector. It also projects continued high unemployment, with the unemployment rate not projected to fall below 6.0 percent until late in the year 2016.

One interesting item is the sharp projected increase in interest costs. In the baseline projections, outlays are projected to rise by 0.1 percentage points of GDP from 22.8 percent in 2012 to 22.9 percent in 2023. However interest costs are projected to rise by 1.9 percentage points, meaning that non-interest spending is projected to fall sharply over this period. (The baseline includes several assumptions that are unrealistic, so it is probably not the best set of projections.)

It is also worth noting that CBO has become very pessimistic about the economy's growth potential and the lower limit on the unemployment rate. It puts potential growth over the decade at just 2.2 percent annually. Part of the explanation is that it expects capital deepening (the increase in the ratio of capital to labor) to make less of a contribution to growth than in prior decades. This is a bit hard to understand since CBO projects that the cost of capital will be low compared to the 1980s and 1990s when capital made a considerably larger contribution to GDP growth.

 

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                        Source: CBO, Federal Reserve Board, and Bureau of Economic Analysis.

The graph shows CBO's projection for the contribution of capital to growth. At 1.0 percentage point annually, the projected contribution of capital growth in the next decade is lower than in the 1970s, 1980s, and 1990s.

This is in spite of the fact that the real interest rate (the interest rate on 10-year Treasury bonds minus the inflation rate) is projected to be considerably lower than in the 1980s and 1990s. Also the fact that the labor force is projected to grow much more slowly should increase the contribution of capital since whatever investment there is will be going to increase the capital labor ratio rather than provide capital to new workers. (If the capital inputs grow by 2.0 percent and the labor force grows by 1.5 percent then the capital/labor ratio increases by 0.5 percent. If capital inputs grow by 2.0 percent and the labor force grows by 0.5 percent, then the capital/labor ratio increases by 1.5 percent.) Obviously CBO did not see it this way.

CBO is also pessimistic about unemployment, assuming that the NAIRU will be 5.3 percent to 5.5 percent for most of this period. That compares to the 4.5 percent rate that we saw in 2007. It's worth noting that CBO has badly over-estimated the NAIRU in the past. In 1996 it projected that the unemployment rate would not get below 6.0 percent in 2000 compared to the 4.0 percent rate we aactually saw. Had that projection proved correct we never would have seen the boom of the late 1990s and we never would have had the budget surpluses at the end of the decade.

Of course CBO has not always been overly pessimistic. In January of 2008, two months after the start of the recession and a full year after the housing market has entered a free fall, it projected nothing but clear skies ahead. And of course in 2009, when the economy was in free fall, it hugely underestimated the severity of the downturn and hugely overestimated the speed of the recovery.

This last prediction was enormously harmful insofar as it played a role in determining policy since it would have led people to believe that President Obama's stimulus was adequate. The country has paid an enormous price because the stimulus was not large enough for the downturn we actually faced, as opposed to the downturn that CBO projected.

 

Comments (2)Add Comment
basic question
written by Jennifer, February 06, 2013 7:59
. . . capital deepening (the increase in the ratio of capital to labor) to make less of a contribution to growth than in prior decades.
I understand your math in the analysis that just by decreases in the population by definition capital should play a larger role, and that for whatever reason the CBO is assuming this ratio is not going to contribute as much in the future as in the past. But I am not sure I know exactly what capital to labor ratio means in real life. I assume capital is assets companies have to invest, if this is the case is an increase in the ratio referring to the idea that companies have more assets compared to labor; is it expected that as this gap increases there should be a increase in growth?
Capital Deepening
written by Dean, February 08, 2013 6:54
Jennifer,

this essentially means that workers are using better equipment. Think of a faster computer with more efficient software or a better Internet connection. With a higher capital to labor ratio, more workers in the workforce will be able to have top of the line equipment.

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