After much anticipation, the CBO has released its Long Term Budget Outlook, which gives the first glimpse at the long-term effects of the recently-enacted health care legislation. In the report, which was released at the third meeting of President Obama's fiscal commission, the extended-baseline scenario (current law) shows drastic improvement from last year's outlook, but the alternative scenario, which is composed of policies more likely to occur, shows a shocking amount of debt.

First, the good news. The extended baseline scenario shows health care spending coming down from levels in the 2009 outlook. By 2083, health spending is about 2 percent of GDP lower than it was projected last year. This decrease is due to both the effects of the health care legislation and to a methdological change by CBO in which they assume lower health cost growth.

Total spending in 2083 is about nine percentage points lower in the 2010 extended baseline outlook compared to last year. About 85 percent of that drop is due to a decrease in spending on interest, which stems mainly from drastically higher revenues that hold debt down compared to the 2009 outlook. Revenues were projected to reach about 26 percent of GDP by 2083 in the 2009 outlook, but this year's outlook projects revenues to reach 30 percent mostly due to tax increases in the health care legislation. The higher revenue obviously decreases the debt, which significantly decreases interest paid on the debt.

Ironically, the biggest driver of the decreased spending in the 2010 extended baseline scenario is higher taxes.

Now the bad news.

While the extended baseline presents a much rosier scenario compared to last year, the alternative scenario paints a fiscal nightmare.  Debt held by the public threatens to break into the quadruple digits (though we would surely never get there), and spending on interest takes up more than half the entire budget by the end of the outlook.

The alternative fiscal scenario assumes that the 2001/2003 Bush tax cuts are made permanent, the AMT and Medicare physician payments continue to be patched, and most importantly, the Medicare spending cuts and slowing of the growth rate of the health insurance subsidies do not occur after 2020.

Under this scenario, primary spending is at 35 percent in 2083, only about 3.5 percentage points higher than current law. However, interest spending is at an astounding 45 percent of GDP, meaning we will be paying more to our creditors than for every government program combined. This leaves total spending at an unbelievable 80 percent of GDP. Revenues don't contribute to debt reduction in this scenario because CBO assumes that lawmakers will change the tax code to keep them at a constant 19.3 percent of GDP after 2020.

The main lessons to draw from this report is that there is still serious work to be done on the spending side.  We must be vigilant to make sure health are cost-cutting measures stick, and we will also need to raise sufficient revenues. Even under the rosy scenario of current law, debt is above 100% of GDP and government is spending is 37 percent of GDP. Those levels are well above historical averages and approaching records. Also, it is unlikely that lawmakers would have the political will to raise anywhere close to 30 percent of GDP in revenues to keep the debt in check. The long term outlook underscores that we have to get to work now to solve our future fiscal problems.

CBO’s Long Term Budget Outlook, released today (see our press release here), paints a more alarming picture of the U.S. debt path than had been previously expected. Under its extended-baseline scenario—assuming the closest approximation of current law to continue in the future—CBO’s 2009 Outlook predicted that our debt held by the public would hit 56 percent of GDP in 2020, and would skyrocket to 128 percent by 2050. Its 2010 revised baseline scenario shows debt-to-GDP at 66 percent by 2020—surpassing the commonly-considered 60 percent sustainable debt level—and reaching 90 percent by 2050.

Yet even more alarming are the numbers predicted under CBO’s alternative fiscal scenario, which is generally considered to be a more likely picture of our future fiscal path, and includes the extension of various tax provisions and other programs set to expire soon. The 2009 Outlook predicted that our debt held by the public would hit 87 percent of GDP by 2020 under these projections, and would more than triple to a whopping 321 percent by 2050—far, far beyond any common benchmark of sustainability. But 2010’s outlook seems even worse: we are now expected to hit the 100 percent of GDP mark by 2023, only a little over a decade from now, and in 2050, our public debt will be almost 350 percent of GDP. In 2084, CBO projects our debt to reach an unfathomable 947 percent.

CBO’s report reflects the importance of acting soon to change the prospects for our fiscal future. With these projected numbers rising year after year while we stay on our current fiscal path, it is clear that we should expect the debt to rise exponentially in the coming decades as well. Unless something is done soon to adjust our growing deficit, it will reach critical and unmanageable levels. It will become harder year after year to return to a sustainable path, and it is thus critical to act now.

Watch for CRFB’s more detailed analysis of CBO’s report soon.

Major legislation reforming the financial regulatory process hit a snag today as Senator Scott Brown (R-MA) said he would not support the bill because it relies primarily on a $19 billion levy on large financial institutions and hedge funds to pay for its costs. At least a couple of Republicans will need to vote for the bill in order to overcome a Senate filibuster and Brown was one of the few GOPers to vote for a previous version of the measure.

It looks like, once again, the matter of offsets has, at least temporarily, derailed major legislation. Leaders in Congress will have to reopen the House-Senate conference process to consider changes to the bill. One option being discussed is to replace the bank tax with bringing the Troubled Assets Relief Program to an early conclusion. Terminating TARP ahead of the scheduled October 3 end date could save $11 billion to use towards the financial overhaul, but we oppose the use of this since it is essentially double-counting savings. A better option is to institute another increase in the fees banks pay to the FDIC.

Congress is still feeling its way through this whole paying-for-legislation thing.

Unbeknownst to the public, Olivier Blanchard and Carlo Cottarelli ascended Mt. Sinai at some point earlier this year. Last week, they came down with the Ten Commandments for Fiscal Adjustment. In their IMF blog post, they make recommendations for how G-20 countries can have successful and productive fiscal consolidations. The commandments are below:

Commandment I: You shall have a credible medium-term fiscal plan with a visible anchor.

Commandment II: You shall not front-load your fiscal adjustment, unless financing needs require it.

Commandment III: You shall target a long-term decline in the public debt-to-GDP ratio, not just its stabilization at post-crisis levels.

Commandment IV: You shall focus on fiscal consolidation tools that are conducive to strong potential growth.

Commandment V: You shall pass early pension and health care reforms as current trends are unsustainable.

Commandment VI: You shall be fair. To be sustainable over time, the fiscal adjustment should be equitable.

Commandment VII: You shall implement wide reforms to boost potential growth.

Commandment VIII: You shall strengthen your fiscal institutions.

Commandment IX: You shall properly coordinate monetary and fiscal policy.

Commandment X: You shall coordinate your policies with other countries.

Commandments I and III are especially central to CRFB's message, and we are working on VIII with the Peterson-Pew Commission on Budget Reform. Commandment II is an important one in the context of the current debate about the timing of cutbacks, and the two took a page out of the Announcement Effect Club when they said "while front-loading fiscal tightening is, in general, inappropriate, front-loading the approval of policy measures...will enhance the credibility of the adjustment." Interestingly, they also took a page out of Paul Krugman's book with the ninth commandment, stating that "if fiscal policy is tightened, interest rates should not be raised as rapidly as in other phases of economic recovery."

However, the crux of the success of fiscal adjustments will be in Commandments IV-VII. Unfortunately, these commandments can sometimes conflict with each other. Generally, economists agree that spending cuts are less harmful to economic growth, which complies with the fifth commandment, but may violate the sixth. Also, the seventh commandment, which emphasizes the promotion of investment, may require new spending or tax cuts that would be at odds with a fiscal consolidation plan. The fifth commandment is an absolute must, but how they do it requires walking a tightrope between growth and equity. Either way, the IMF's Ten Commandments show that HOW you consolidate is important along with IF you consolidate.  

The declaration from the G2O meetings in Toronto this past weekend sounds, at first, to be taking a strong stance on fiscal consolidation.

“There is also a risk that the failure to implement consolidation where necessary would undermine confidence and hamper growth. Reflecting this balance, advanced economies have committed to fiscal plans that will at least halve deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016.”

Ok, that sounds pretty good, but wait a second. Halve deficits? This is that old game started in the Bush years and taken up by the Obama administration of halving something from a completely nutso starting point and calling it a victory. It’s like setting a goal of losing half your pregnancy weight.

The projected deficit for 2010 is 10.3% of GDP. It would drop to 4.5% by 2013 under the President’s budget. Under a current law scenario, it is projected to be 3.1% of GDP that year—so significantly better. Economic improvements alone are easily expected to cut the deficit in half by 2013 – this requires no change in policy in the U.S. So not exactly a heavy lift.

But then again, what happens in 2013 is probably less important than thereafter. The goal of stabilizing the debt by 2016 is a big deal. Keeping the debt-to-GDP ratio stable requires that the long-term deficit problems—driven by healthcare costs and aging—are addressed. You can’t get there any other way. This would be a huge accomplishment.

Not allowing the debt to grow faster than the economy is necessary to get control of the situation, as is getting debt levels back down to a manageable level where fiscal flexibility is preserved. We have recommended 60% by 2018 and lower thereafter. Anything higher would leave the U.S. without the fiscal firepower to respond to future crises.

As we have said before, we need both a medium-term goal and a long-term goal, both of which are included in the G20’s Declaration this weekend.

An important question is whether these G20 targets are credible. President Obama did not emphasize the fiscal targets in his remarks, and his administration is currently more focused on stimulus measures than specific measures to get the budget under control. But there needs to be a credible commitment to budget reform to reassure financial markets and keep our interest rates from rising. Also, given the political environment, it appears there will be little appetite for further stimulus measure unless important measures are taken that will get the debt under control.

The best path forward—something recognized in the G20’s Declaration—is an emphasis on necessary short-term stimulus along with putting in place medium-term budget plans. The U.S. needs to focus on both. Rather than pairing back stimulus measures, the key here is to craft effective short-term stimulus while putting in place the medium-term budget changes. Other countries are ahead of us on this piece, and the U.S. should step up the emphasis on policy changes to get the budget under control. Without growth and a credible consolidation plan, our fiscal situation will remain precarious.