Assumptions Equal Problems
John Mauldin
The future is tantalizing because it is both unknown and
unknowable. At best, we can make educated guesses about tomorrow or next year.
Sometimes, it’s actually hard to understand what happened in the past, much
less to chart how the future might unfold.
The problem is that some guesses are more educated than others,
and even the best are often not good enough. This fact of life matters because
we use those guesses to make important decisions about, for instance,
government tax and spending policies. Mistakes can have terrible consequences.
These are subjects on which it is hard for any of us to be truly
neutral. Most people want to lower their own taxes and simultaneously see more
spending on whichever services they think government should deliver. The politicians
we elect know this, so they try to give us what we want. The charade never ends
well, but we and they keep at it.
Today we will look back at what economists thought the federal
budget and tax policy would be in 2001 and thereafter. Let’s just say the
government projections were a tad optimistic.
Photo: Getty Images
The Best of Times
Dial your mind back to January 2001. The world had survived Y2K;
the stock market was topping out; George W. Bush had moved into the White
House; and the US government had a balanced budget.
Wait, say that again? Yes, the budget was balanced, and indeed we
were running a surplus. Actual black ink. How did that happen? For one thing, a
Democratic President Clinton and a Republican Congress led by Newt Gingrich had
found ways to work together and get things done. But more important was the
previous decade’s economic boom, including four
consecutive years of 4.4% or better real GDP growth. Truly it was
the best of times, economically speaking.
Photo: Wikimedia Commons
This happy situation would not last long, but many intelligent
people sure thought it would. In researching this letter, I poked through news
articles from the time and found a treasure trove of horribly
embarrassing-in-hindsight quotes. Some were from experts quite well-respected
now – perhaps in part because they learned something from being so wrong then.
Five days after the Bush inauguration, then-Fed
chair Alan Greenspan testified before the Senate Budget Committee. Congress
was considering how to spend a rapidly accumulating budget surplus. Jerome
Powell can only wish for the chance to say something like this:
The most recent projections from the OMB indicate that, if current
policies remain in place, the total unified surplus will reach $800 billion in
fiscal year 2011, including an on-budget surplus of $500 billion. The CBO
reportedly will be showing even larger surpluses. Moreover, the admittedly
quite uncertain long-term budget exercises released by the CBO last October
maintain an implicit on-budget surplus under baseline assumptions well past
2030 despite the budgetary pressures from the aging of the baby-boom
generation, especially on the major health programs.
The most recent projections, granted their
tentativeness, nonetheless make clear that the highly desirable goal of paying
off the federal debt is in reach before the end of the decade. This is in
marked contrast to the perspective of a year ago when the elimination of the
debt did not appear likely until the next decade.
Greenspan went on to give all the usual qualifiers, but his point
was clear: Paying off the debt was both desirable and possible. He was so
confident of it, he described at length the practical challenges of prepaying
all the outstanding long-term Treasury bonds.
In February of 2001 I wrote about the growing budget surplus; and
in that letter, entitled “Greenspan
Interpreted,” I and others talk about some of the problems of not having US
Treasury debt for many businesses, especially financial businesses, that
actually are required to hold US debt. I smile as I go back and read those
letters.
These particularly optimistic paragraphs leap out at me:
#1. There was a remarkable exchange with the new Senator from
Michigan. She was sticking to the questions her staff had prepared for her
(generally good practice for freshman senators when talking to Greenspan), when
all of a sudden she thought she had this brilliant insight that would support
her position that tax cuts are bad. Basically, she asked, “Do I understand you
to be saying that in 2005 we will only have $500 billion in surplus?” getting
ready to imply that the surplus was not really going to be enough for tax cuts.
(Her staff had to be cringing when she left her script.) Before she could
really put her foot in her mouth, Greenspan graciously interrupted and said,
“No, Ma’am, I am saying that without tax cuts the surplus will be $500 billion
in ONE YEAR. There will be no debt to buy. We will have to do something with
that money. Whatever it is will be a huge stimulus to the economy.” His implied
threat was that he would have to raise rates, cut the money supply, or do
something equally nasty to offset that type of stimulus.
Greenspan plainly said that 5–6 years ago no one could have
credibly argued we would be where we are today. No one thought that we could
remotely pay off the portion of the debt that is not held by Social Security
and Medicare as early as 2005–2006. Then he asked throughout both hearings, as
I have done over the past months, what do we do with the “excess” surplus,
especially the Social Security and Medicare surplus? Put it in a lockbox? Buy
corporate bonds? Buy stocks?
These are all good problems, but they are going to be problems,
nonetheless. He basically insisted that Congress needs to begin to decide now
what we are going to do.
As for him, he clearly favored tax cuts. It would provide a steady
stimulus, rather than a massive one. It would postpone the problem of paying
the debt to a manageable period.
In other words, Greenspan saw eliminating the federal debt as a
matter of “how,” not “if” – if, as he said, current policies remained in place.
Obviously, it didn’t happen that way. Congress and the Bush administration
decided to cut taxes and add the Medicare Part D prescription drug benefit.
Then September 11, 2001, precipitated the very costly War on Terror.
(Note: At the time Greenspan said all this, the US economy was
only weeks away from entering a recession. It would be short and relatively
shallow but still an honest-to-God recession. Keep that in mind when you hear
today’s experts confidently predict further growth.)
The Congressional Budget Office (CBO) surplus projections
Greenspan mentions are still
online here. Then, as now, the economic assumptions were optimistic, to say
the least.
As of January 2001, the CBO foresaw another decade of 3% real GDP
growth, 3% inflation, unemployment at 5% or below, and flat-as-a-pancake
interest rates. That scenario was never likely to happen, and indeed it did
not. These assumptions fell apart almost immediately and the situation only
worsened. But by then the assumptions had been used to justify decisions that
were, for various reasons, all but irreversible.
In fairness to the CBO, their report discussed how the projections
could go wrong.
They even disclosed their own historical inaccuracies. But
because this was a political process and not a business or scientific one,
those warnings received little heed.
I have talked about this before: All economic and budget models
are based on assumptions. Those assumptions generally draw upon the past to
make projections about the future. I have actually heard a well-respected Fed
economist admit that using the Phillips curve for some of their projections is
fraught with problems. When asked, “Then why do you keep using it?” the answer
that came back was, “We have to have something that we can base our projections
on. We don’t have any other better model, so we use it.” Knowing that its us is
going to result in faulty predictions, they still use it anyway.
And knowing that government agencies that do budget projections
are forced to make assumptions about an unknowable future, we shouldn’t be too
critical of them. Then again, because they are government entities, they are
disinclined to forecast recessions or anything that might be negative about the
economy. Generally, government forecasts are packed with lots of rainbows and
ponies.
Nevertheless, the 1990s surplus wasn’t imaginary. And it was
growing. The government was taking in more cash than it was spending. The
overall debt had stopped growing and may have even shrunk a little, depending
how you defined it. That was good.
Now, 17 years later, the surplus is gone, and we could easily see
a $2 trillion annual deficit soon. How did we get from there to here so fast?
The answer is in the assumptions.
If your average picture is worth a thousand words, the one below
is worth many more. It comes from former Treasury economist Ernie Tedeschi. On
his Twitter page, Ernie pointed out that seemingly reasonable assumptions
back at the time of the January 2001 surplus celebration would have added up to
a $15 trillion cumulative budget surplus through 2028.
That would have been nice, and probably allowed Greenspan to be
right about paying off the debt. It didn’t happen. Instead, Ernie now foresees
a $28 trillion cumulative deficit. In other words, over a 27-year period the
assumptions will have been about $43 trillion off, if Ernie is right. Maybe
he’s not, but let’s go with his numbers for the sake of argument.
What accounts for that gaping difference? Lots of things, but they
fall into three broad categories, none of which are surprising.
• Higher than expected government spending
• Lower than expected tax revenues
• Worse than expected economic growth
• Lower than expected tax revenues
• Worse than expected economic growth
Ernie’s chart breaks down the effect of each wrong assumption.
Note that the October 2000 long-term projections from the CBO anticipated $15
trillion in savings by 2028.
Source: Ernie Tedeschi. Reproduced with permission
Let’s dig into this chart. Start by finding 2011 at the bottom
axis, then go up. That’s the 10-year projection period CBO published in the
2001 report linked above. It’s history now, so we can evaluate it without
making further assumptions. You can see the gap at that point came in roughly
equal proportions from missed spending and missed revenue estimates. GDP had a
relatively small effect, even though the original projections didn’t assume the
2007–2009 recession. When all was said and done, the 10 years ending 2010 saw
an average of less than 2% GDP growth per year. And all that lost growth began
to show up in the form of budget deficits this decade.
As time passes, the consequences of excessive GDP optimism grow
more significant, especially as the CBO now projects lower growth than it did
in 2001. Lower growth shrinks revenues. When these impacts are compounded over
time, the difference between 2% and 3% real GDP growth is enormous. Just as
those repeated years of 4% and better growth in the 1990s added up to a
stunning surplus, our recent string of 2% and worse years add up to the opposite
– and will keep doing so, unless something sparks much higher growth.
GDP projections involve both revenue and spending. Lower GDP and
especially recessions tend to mean higher spending as more people become
eligible for unemployment benefits, food stamps, and other social programs.
Congress uses recessions to justify “stimulus” spending, too.
Likewise, recessions or just lower growth mean lower revenue
because our tax system depends mostly on income. Less income for people and
businesses means less tax revenue for the government.
But even if the CBO were to estimate GDP on the dot, and even if
tax policy stayed constant, spending is still a huge variable. The services we
want government to provide change over time. So does the composition of
Congress, which decides which services to provide. Spending grows under either
party, but not in the same ways. Then there are occasional bolts from the blue
like 9/11, which in short order led us to spend multiple trillions on wars in
Iraq and Afghanistan and smaller involvements elsewhere.
We can’t blame the CBO for not knowing how much those wars would
cost or how long they would last, even if it could have somehow anticipated
them. To a lesser degree, that is also true of budget busters like natural
disasters. We can go years without needing to spend much on them and then have
several hit at once.
There are ways to handle the unexpected. Keep the budget balanced
or run a small surplus, then have a “rainy day” fund for emergencies. That’s
how families and businesses operate. The government could do the same if the
political will existed. Obviously, it doesn’t.
This example of how badly assumptions can go wrong offers some
valuable lessons. Forecasting the future is hard even in the best circumstances,
but you must make assumptions in order to plan ahead. The key is to make
conservative, reasonable assumptions and adjust them when they prove wrong.
(I am facing that problem head-on every day as I try to write my
new book on what the world will look like in 20 years – knowing that I’m going
to be laughably wrong at various points along the way. I hope to be right more
than I’m wrong. But the problem is, I’m obliged to makes scores of forecasts.
So I have to make the best assumptions I can and move forward.)
That’s not how our federal government works. It makes hasty
decisions and then compounds the bad effects. As noted above, we had a giant
surplus on hand when the economy entered recession in early 2001. A little
stimulus via tax cuts or extra spending made sense. Was that still the case
after September 2001? Or should the government have changed course to account
for new circumstances? As it happened, we kept the tax cuts, added new military
and Medicare spending, and did nothing to raise new revenue or cut other
spending. Bye-bye, surplus. Then came the financial crisis and Great Recession,
and and you know the rest.
Even with wars and two recessions, we might have avoided today’s
huge deficits if GDP growth hadn’t fallen to this frustratingly low plateau.
The last calendar year with real GDP growth over 3% was 2005. Some people think
2018 will be the next one. I doubt it, but even if that happens it won’t make
up for the years of missed growth opportunities.
All that said, this problem isn’t unsolvable. Growth really is the
key. If real GDP can jump 3% or more this year and keep doing the same thing
for three or four more years after that, and we can put in place some spending
reductions, we would go a long way to solving our deficit problem. We might not
have a surplus, but we’d be much closer to balanced.
Unfortunately, I can’t presently imagine a scenario in which that
happens. The tax cuts and deregulation are helping a little, but not enough.
Picking trade wars with China or tearing up NAFTA won’t help at all. Nor will
continued gridlock over healthcare, or failure to solve the public pension
problem or to reform entitlement spending. On the monetary side, it’s clear the
Fed has no magic bullets. So what’s the best-case scenario?
I can only imagine one event that might help: a positive bolt from
the blue, one that reduces government spending and raises government revenue.
Sound like a dream? Maybe it is, but I can imagine some major
healthcare breakthroughs that would do it. Cures for Alzheimer’s, cancer, and
heart disease would be a huge help. So would anti-aging breakthroughs. People
would be able to work longer, adding productivity to the economy while reducing
Social Security and Medicare spending.
Mind you, I am not predicting those things will happen soon – but
I don’t count them out, either. Smart people are working on all these
challenges and making progress. A large part of the budget problem is really a
healthcare problem, both directly and indirectly. Healthier workers with longer
working careers will translate directly into economic growth.
Today’s debt problem traces directly back to those 2001
assumptions that proved so wrong, but that’s not all. Every subsequent Congress
and administration has relied on equally flawed, implausible assumptions and
made similarly flawed decisions, right up to the present one. This
short-sighted, wishful thinking afflicts both parties and the nation. It is a
systemic problem that requires a systemic solution. Playing the blame game will
not fix it.
And just for the record, I would like to say that the $28 trillion
debt projected for 2028 is going to be seen in hindsight to have been
extraordinarily optimistic. I think we are at $30 trillion of total debt by the
middle of the decade, and by the end of the decade we could be scaring $40
trillion. We are beginning to see the drag on growth brought about the
inexorable rise of total (not just government) US debt.
As I’ve said many times, we can’t pay that debt down through any
realistic budget process. We, along with the rest of the countries in the
developed world, are going to have to take extraordinary measures to control
and reduce our debts and interest payments. I’ve called it the Great Reset.
There are several ways to reduce the debt, but they all amount to essentially
changing the terms of the debt (an anathema) or some form of monetization.
Making such a prediction now seems rather stark, as any of those choices will
not be popular or pleasant, so they are unthinkable today. But when we have our
backs to the wall, we will all start thinking about unthinkable things and
actually doing some of them.
All the while, technology is encroaching on more jobs, and the
politics of many countries are becoming increasingly harsh. The 2020s are going
to be extraordinarily volatile in so many ways – which of course means that
there will be lots of opportunities. Stay tuned.
I travel next week to Charlotte, then later in the month to Fort
Lauderdale, Chicago, and Raleigh for mostly private speaking engagements. The
exception is a seminar
open to financial advisors and brokers and sponsored by S&P, happening
in Charlotte on April 11. The event is built around the theme of strategic and
tactical ETF trading strategies.
Thank you to the thousands of you who took the survey I shared
last week. My team is crunching through the results as I write, but some
interesting findings jumped off the page straight away. One I found
particularly interesting is that a massive 82% of you prefer to receive
investment information by email.
It’s wonderful to know that, some 18 years after I first started
sending out Thoughts from the Frontline, you still enjoy opening it up and
reading it each week. I truly do appreciate that investment of your time in an
era when we’re all battling the overload in our inboxes.
And I want to thank you, too, for the time you took to share your
thoughtful and detailed answers about where we go from here with both Thoughts
from the Frontline and Outside the Box.
Thankfully, your vision and mine converge pretty closely. That
makes me even more excited about unveiling my plan to you. I’m still dotting
some i’s and crossing some t’s, as well as conducting an avalanche of meetings,
but I can say for certain that I’ll be able to let you in on what’s happening
within a couple of weeks. Stay tuned!
You have a great week. I can reliably project that I will be
watching the Masters this weekend. Having been at Augusta last year for the
Masters, I have a much better sense of what it’s like, and that will make
watching it on TV a lot more fun.
Your thinking about the Great Reset analyst,
John Mauldin
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