A Few Critical Flaws in Fed Debt Projections That You Should Know About

A Few Critical Flaws in Fed Debt Projections That You Should Know About

Last night I was reviewing the Congressional Budget Office’s recent outlook to get a handle on their assumptions (I know, an exciting Monday night!)

One of our astute readers kicked off this exercise by taking a look at the government’s debt and interest rate projections out to 2015, concluding that the call by many that higher interest rates as an inevitability is incorrect.

Reason being that debt payments at higher interest rates would not be possible with debt levels of this magnitude.  As has been the case in Japan, rates HAVE to stay low, or it’d be game over.  More on this below.

For starters, I’d like to review some of the assumptions laid out by the CBO (whose projections are historically inaccurate – usually comically so) to see how much risk and probability we have to the downside – both in terms of total debt, and interest payments on that debt.

First up – revenues and expenditures.  The CBO says right now is as “bad as it’s gonna get” in terms of yearly deficits.  From here we close the gap to “more manageable” levels:

CBO Deficit Projections 2010

This assumes low rates until 2012, and rate hikes through 2015 that would bring the 3-month rate to 4.9%, and the 10-year rate to 5.9%:

CBO Interest Rate Projections 2010

Source: Congressional Budget Office

One glaring problem with top-line estimates above is that the CBO is projecting 4.1% GDP growth annually from 2012 through 2014:

Given its assumptions about fiscal policy, CBO projects that real (inflation adjusted) gross domestic product will increase by 2.8 percent between the fourth quarters of 2009 and 2010 and by 2.0 percent in 2011 (see Table 2-1). After 2011, the projected growth of real GDP picks up, averaging 4.1 percent annually from 2012 through 2014 and closing the gap between GDP and its potential level (the amount of production that corresponds to a high rate of use of labor and capital resources) by the end of 2014 (see Figure 2-1).

Anyone want to take the other side of that trade?

And here’s my favorite:

The modest growth in output projected for the next two years points to sluggish growth in employment during the remainder of this year and next. Consequently, the unemployment rate in CBO’s projections declines slowly, falling to 9.3 percent at the end of 2010 and 8.8 percent at the end of 2011 (see Figure 2-2 on page 32). After 2011, growth in employment picks up along with growth in output, and the unemployment rate declines more rapidly, reaching 5.1 percent at the end of 2014.

Be sure you view the projections below with rose-colored glasses – otherwise, they may seem preposterous!

CBO Unemployment Projection

Source: Congressional Budget Office

Nevermind the legions of “underemployed” though – apparently even the CBO didn’t have the stomach to spin the future of this disastrous runaway train:

CBO Long Term Unemployment

If we, for sake of argument, accept the above projections at face-value, then we are looking at annual interest payments that will head towards $1 trillion dollars by the end of the decade:

Source: NPR.org

Which is ugly, but not “end of the world” ugly.  The debt holds at approximately 67% of GDP – which is not quite in “default red-zone” territory.

Though you can see, a few tweaks to the formula, and we’re likely right there.

For a good expert perspective, NPR article quotes Kenneth Rogoff of This Time is Different fame – who concurs with our questioning of these assumptions:

CBO’s projections actually rest on fairly optimistic assumptions about growth and interest. Under not particularly fanciful alternative scenarios, annual debt payments could turn out to be more like $1.5 trillion, says Kenneth Rogoff, a Harvard University economist.

Rogoff, whose work on the history of financial crises is widely cited, doesn’t think the U.S. would face a crisis akin to the one currently ravaging Greece and threatening to spread across Europe. Still, it won’t be pretty.

“In Greece, it’s happening faster than you can blink,” he says. “In the U.S., it would be interest rates rising painfully and slowly over several years. We would adjust, but that doesn’t mean it’s not going to be painful and slow our growth.”

Rates rising “painfully and slowly” is certainly a departure from the bond vigilantes of the 1970’s riding back into town to extract pain and misery from the irresponsible spending Federal government.  Then again, as mentioned above, it probably must be a slower feast, otherwise the entire host would be killed if interest rates spiked severely, which would signify GAME OVER

In conclusion, we can probably figure that government assumptions are too rosy – debt levels are going to be greater than advertised.  Which means that capping interest rates is going to be extremely important to the Federal government.

Can they do it – or at least kick the can way down the road, like Japan’s been able to do (so far)?

Big hat tip to our correspondent Dr. Evil for contributing to this story!