Why Obama’s Budget Is Not Sustainable

Harvard Economist Gregory Mankiw explains why President Obama�??s budget is unsustainable, even from Mankiw�??s New Keynesian perspective. From his latest New York Times column:

The troubling feature of Mr. Obama�??s budget is that it fails to return the federal government to manageable budget deficits, even as the wars wind down and the economy recovers from the recession. According to the administration�??s own numbers, the budget deficit under the president�??s proposed policies will never fall below 3.6 percent of G.D.P. By 2020, the end of the planning horizon, it will be 4.2 percent and rising.

As a result, the government�??s debts will grow faster than the economy. The administration projects that the debt-to-G.D.P. ratio will rise in each of the next 10 years. By 2020, the government�??s debts will equal 77.2 percent of G.D.P. This level of indebtedness has not been seen since 1950, in the aftermath of the borrowing to finance World War II.

Making matters worse, these bleak budget projections are based on relatively optimistic economic assumptions. The administration forecasts economic growth of 3.0 percent from the fourth quarter of 2009 to the fourth quarter of 2010, followed by 4.3 percent the next year. By contrast, the Congressional Budget Office predicts growth of 2.1 percent and 2.4 percent for these two years. Lower growth would mean less tax revenue, larger budget deficits and a more rapidly increasing debt-to-G.D.P. ratio.

In other words, the Obama administration has made a bet that the economy will return to its pre-crisis growth path through the immense boost in spending. This would relieve the fiscal pressure, as a growing economy would imply lower entitlement spending for unemployment and higher tax revenues. The effect of growth on the fiscal strength of a country, is why Mankiw thinks that �??the government can run budget deficits in perpetuity, as long as they are not too large�?�, i.e. that the annual budget deficit isn�??t larger than the economic growth rate, which some see as the very definition of a sustainable budget.

However, this seems highly unlikely, as a growing public sector and growing public debt will only work as a drag on the economy in the years to come. At the same time, the massive misallocation of resources that took place in the 2000s boom (think x, y, z) has to be reallocated, that is shifted back to sectors where the now misplaced capital and labor will actually create wealth. This process could take some time, and is not helped along by the government trying to create temporary work through public spending programs, or trying to prop up sectors, such as housing, that need restructuring.

Furthermore, the financial crisis could be seen as the necessary market correction to a boom that was characterized by too much debt and not enough savings, both in the public and private sectors. As both households and financial firms need to deleverage to return to a more sound financial footing, this will obviously create an economic environment radically different from the one seen in the two decades preceding the crisis. This process is highly necessary, though, for the long-term health of the economy. The federal government�??s attempts at curing the economy through running up even more debt, will at best only create the impression of improved economic conditions in the very short run �?? though. economists are even debating whether this is actually the case �?? and will not solve the underlying problems, which is too much debt, misallocation of resources, and a nation �??living beyond its means�?�.