Slowing Economy Could Exacerbate Debt

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Fiscal retrenchment is like driving up a steep, muddy hill in a downpour. If the economy moves too slowly, it might lose traction or even start backsliding as more debt accumulates.

Now, as the fiscal climb begins — unless Congress prolongs stimulus and tax cuts — the apparent economic downshift could make budget progress difficult.

The White House's Office of Management and Budget sees 4% average real GDP growth from 2011 to 2014. But if growth is 3%, OMB says deficits would be $2 trillion higher through 2020 than the $8.5 trillion under its baseline scenario.

A one-percentage-point shortfall in growth each year from 2010 to 2020 would raise deficits by $3.1 trillion.

Instead of a debt-to-GDP ratio of 77% in 2020, as OMB projects, the latter scenario of persistently slower growth would push that to 99%.

That slower growth scenario assumes the stimulus unwinds and the White House's budget prescriptions are on schedule. Proposed tax hikes on higher earners, corporations and the middle class with the phasing out of President Obama's Making Work Pay $400 tax credit would amount to $1 trillion the first five years, reaching $285 billion in 2015.

Even so, slower growth would have a much larger deficit impact than delaying big tax increases for a couple of years.

University of California, Berkeley, economist Alan Auerbach argues that debt levels are still manageable enough that it makes sense to give the economy more running room to solidify the recovery before embracing austerity.

"I think the best strategy — which is not one that is politically likely — is to not worry so much about the short-term debt accumulation but to take very forceful action" to address long-term deficits tied to health care spending and Social Security, Auerbach said.

The risk, said former Congressional Budget Office director Rudy Penner, is that a "dysfunctional" Congress will delay action on that longer-term problem and foreigners will begin to shun Treasuries, or at least demand a premium.

A one-percentage-point hike in real interest rates from 2010-20 would raise projected deficits by $845 billion, OMB estimates.

Another downside fiscal risk is that neither OMB nor the CBO tries to predict future recessions .

After the U.S. returns to full employment — a 5.2% jobless rate in 2018 — OMB projects steady, if unspectacular, 2.5% growth.

Lakshman Achuthan, managing director of the Economic Cycle Research Institute, argues that the economy has evolved in ways that haven't been built into the budget crunchers' models.

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Posted By: GLOBE TRADER(105) on 7/19/2010 | 9:49 PM ET

Can you hear the helicopters..??

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