We are now five years into what is arguably the worst recovery in the post-war era, but we may finally be picking up a little steam. This may not be apparent from the first-quarter 2014 GDP report, which showed that the economy grew at a 0.1% annualized rate. However, underlying this low headline number were a number of factors suggesting that better times may be ahead.
The Economic Outlook
Much of the slow growth was due to abysmal weather conditions and a sizable inventory correction following a build-up over the last half of 2013. Business investment and net exports were unexpectedly weak. Yet net exports are often volatile, and with a big jump in the fourth-quarter some retrenchment was to be expected. We anticipate some improvement in the coming months because industrial production and capacity utilization are both continuing to rise, albeit modestly. Net exports should also get back on track as growth abroad continues to improve and U.S. energy production reduces the need for imported oil.
Personal consumption expenditures, which represent over two-thirds of GDP, rose 3.0% after growing 3.3% in the fourth-quarter. And monthly data on personal income and consumption in March were strong, providing an optimistic note for growth later in the year.
The latest job numbers for April showed a surprisingly robust 288,000 jobs created, and the prior two months were revised up by a combined 36,000. Thus, the average for the first four months of the year was 214,000, up from 185,000 in the second half of last year. The unemployment rate declined to 6.3% from 6.7% in March due to a decline in the participation rate. In fact, April’s household survey, from which the unemployment rate derives, showed a net drop in employment. When all is said and done, we are still more than 100,000 jobs below our prior peak, but we are getting close.
With energy prices relatively steady and wage pressure light, inflation has remained completely benign. And the Federal Reserve has remained aggressively accommodative despite the reduction in asset purchases.
For all these reasons, we remain guardedly optimistic that the economy will gradually accelerate through the year and reach about a 3½% annual growth rate by year-end—assuming no powerful shocks from geopolitical developments abroad.
While it is nice to be able to forecast some improvement in the economy, it also raises some concerns over longer-run issues. Our forecast was relatively close to what the Congressional Budget Office (CBO) included in its most recent analysis of the U.S. fiscal situation, and the conclusions of the CBO’s analysis were anything but sanguine.
The Budget Outlook
The CBO’s latest budget outlook projects that deficits will gradually decline from $680 billion in 2013 to $492 billion in 2014 and $469 billion in 2015. Though still astounding figures, they are down considerably from the prior four years when the government ran deficits over $1 trillion. The era of $1 trillion deficits is not behind us however. Starting in 2016, the CBO expects deficits to deteriorate and to reach just over $1 trillion in 2023 and 2024.
The short reprieve from rising deficits over the next two years will help stabilize the debt to GDP ratio, which is expected to gradually decline from 73.8% in 2014 to 72.4% in 2017. This stability does not extend to the long run, and by 2018 the CBO expects the debt to GDP ratio to be trending up again. By 2024, the ratio is projected to reach 78.1% and steadily rise.
The administration has emphasized the role of revenues in our deficit story. As a result of tax increases and improvements in the economy, revenues have rebounded since the recession, rising from only 14.6% of GDP in 2009 and 2010 to 16.7% in 2013. The CBO expects revenues to rise rapidly over the next two years to 17.6% in 2014 and 18.2% in 2015. Revenues are expected to remain above 18% throughout the CBO’s forecast, a level above the historic norm of 17.7% (1980–2007). Despite the rhetoric, we do not appear to have a problem raising sufficient revenue.
The real culprit behind rising deficits and debt levels is on the spending side. Over the 1980–2007 period, spending averaged 20.2% of GDP. The recession and the subsequent policy response led to sharp increases in government outlays. Spending rose from 19.0% of GDP in 2007 to 24.4% in 2009. Spending has gradually retrenched as the stimulus funding faded and automatic fiscal stabilizers, such as unemployment insurance benefits, diminish.
Outlays have since declined to 20.8% in 2013 and are expected to decline in 2014 to 20.4% of GDP. Outlays are then projected to begin an inexorable rise over the remainder of the forecast, reaching 22.1% of GDP in 2024, well above our historical average.
The reason that we are unable to get our spending under control has little to do with spending on defense and other discretionary outlays. Total discretionary spending is projected to only rise from $1.2 trillion in 2013 to $1.4 trillion in 2024. As a share of GDP, it is projected to decline from 7.2% in 2013 to 5.1% in 2024.
The primary forces driving our spending are the long-term effects of an aging population, growing health care costs, and rising interest costs. Entitlement spending, which includes Social Security, Medicare, Medicaid, and other income security, is projected to rise from $2.0 trillion in 2013 to $3.7 trillion by 2024. As a share of GDP, entitlements are expected to rise from 12.2% in 2013 to 13.7% in 2024.
Reforming our entitlement system must be a priority. Our entitlement programs will not be able to pay their promised benefits in 20 years. To consider just one example, absent explicit reforms, Social Security benefits would have to decline by almost 25% in 2033 to align with revenues. Our entitlement programs have been adjusted and reformed in the past, and there is no reason to fear carefully crafted, phased-in adjustments. The biggest danger to our entitlement programs is inaction, which will eventually trigger massive benefit cuts.
Rising expenditures on mandatory programs present challenges for policymakers who wish to set our fiscal house in order. Running continuous budget deficits also raises our interest costs.
GDP and the Debt
As long as the level of debt to GDP remains near current levels and interest rates are relatively low, government interest expenses will remain manageable. But when interest rates rise, debt service payments rapidly become an increasing share of our annual deficit. If we are unable to rein in our soaring entitlement costs, net interest on the public debt is projected to rise from $221 billion in 2013 to $876 billion by 2024. As a share of GDP, net interest is projected to rise from 1.3% in 2013 to 3.3% in 2024.
Interest rates on our debt are at historically low levels. But with continued economic recovery and the Fed set to raise rates in late 2015 or early 2016, our debt service payments will increase as well.
The fact that the near-term outlook has improved should not distract us from the long-term challenges facing our economy. We must get the deficit and debt situation under control and should begin that process before we experience another economic downturn. Expansions in the post-war era have historically lasted about 5½ years. Now, we are not projecting a recession in the next six months, but this expansion will not last forever. If we don’t act soon during the relatively good years, we will be unable to address the situation when the outlook worsens.