The issue, of course, is a hot button, in that a number of political analysts, policy experts, economists, and investors appear to believe that strong deficit reduction – either through increased taxes or budget savings through entitlement reform and federal workforce reduction – would equate to below-trend economic growth.
The Congressional Budget Office (CBO), on the other hand, came to the exact opposite conclusion.
Source: Congressional Budget Office
In the CBO’s recently released report, the CBO projects that if the President and Congress agreed to a $2 trillion increase in primary deficits – in other words another $2 trillion in stimulus spending – the effect would initially be an increase in overall economic growth. The effect of increased spending would quickly fade into a fiscal drag on the economy, though, with mounting debt creating an economic drag after a few years of short-term spending.
The CBO also looked at two alternative scenarios involving $2 trillion and $4 trillion in deficit reduction. Their conclusion, contrasting sharply with the consensus investor view, is that these two scenarios initially have a fiscal drag of around a half to a quarter of a percent of total economic growth. After the initial downside effect, though, the CBO finds that economic growth becomes stronger, with the effect of say a $4 trillion deficit reduction package increasing overall economic growth by about one and a half percent ten years after enactment.
The differences between the CBO’s view and what appears to be the political and investor consensus largely depends (implicitly assumed) upon behavioral assumptions regarding saving, investment, and consumer/business confidence.
Of course, differences in behavioral assumptions don’t completely explain the differences between the two conclusions. Perhaps the largest difference is the weight the two competing groups place on the real effect of additional debt burden. One group generally ignores the long-term effects of increasing the debt burden (i.e. there’s no straw that breaks the camel’s back), while the other accounts for the fact that additional straw may not break the camel’s back, but it does slow the camel down.
There are a few other important notes on the CBO’s analysis.
The first is that the CBO’s report is more general in nature, meaning that it doesn’t address the differential effects between tax increases and cost savings (spending reductions).
The second caveat is that the CBO assumes cost savings (spending reductions) or cost increases (tax increases) happen though phasing in. If deficit reduction happens in more of a shock-and-awe fashion, the end effects could turn out quite different.
The third issue is that productivity is absent from both schools of thought. Presuming the federal government reduces costs by eliminating unneeded statisticians, auditors, administrative professionals, and many others, in conjunction with entitlement reform, aggregate productivity should increase.
How does overall productivity increase? Well, as individuals shift from government employment or no employment at all, where productivity is generally lower, to more productive employment, such as being business owners, overall productivity improves.
The question is: where are private equity professionals on the issue? In general, they’re probably in the consensus investor camp, confusing a small short-term economic drag with a long-term improvement in the overall economic outlook. Anyone disagree with this conclusion? Although probably incorrect in the vast majority of cases, the industry doesn’t really have a good reputation of concern for long-term economic health. Is this incorrect stereotype accurate when it comes to this issue?
Overall, as long as deficit reduction is done in a responsible manner and generally accomplished through cost reductions (reducing spending), the long-term economic outlook probably improves, contrary to what appears to be consensus investor opinion.