Wed, Apr 18, 2012 - Page 9 News List

Budgetary wishful thinking

Overly optimistic projections caused economic blundering in industrialized nations

By Jeffrey Frankel

Illustration: Taipei Times

Why do many countries find it hard to control their budgets? Concern about budget deficits has become a burning political issue in the US; it helped to persuade the UK to enact stringent cuts despite a weak economy; and is the proximate cause of the Greek sovereign-debt crisis, which has grown to engulf the entire eurozone. Indeed, among industrialized countries, hardly anyone is immune from fiscal woes.

Clearly, part of the blame lies with voters who don’t want to hear that budget discipline means cutting programs that matter to them, and with politicians who tell voters only what they want to hear. However, another factor has attracted little notice: systematically over-optimistic official forecasts.

Such forecasts underlie governments’ failure to take advantage of boom periods to strengthen their finances, including running budget surpluses. During the expansion of 2001 to 2007, for example, the US government projected that budget surpluses would remain strong. These forecasts supported enactment of large long-term tax cuts and faster spending growth (both military and otherwise).

European countries behaved similarly, running up ever-higher debts. Not surprisingly, when global recession hit in 2008, most countries had little or no “fiscal space” to implement countercyclical policy.

The US Office of Management and Budget (OMB) has perennially turned out optimistic budget forecasts. For eight years, it never stopped forecasting that the budget would return to surplus by last year, even though virtually every independent forecast showed that deficits would continue into the new decade unabated. The US projections were overoptimistic even at short-time horizons. From 1986 to 2009, the bias averaged 0.4 percent of GDP at the one-year horizon, 1 percent at two years and 3.1 percent at three years.

Sanguine macroeconomic assumptions and fanciful theories about the effects of tax cuts underpinned rosy scenarios. From the quarter-century until 2009, the OMB’s three-year forecasts of economic growth were biased upward by 3.8 percent on average.

However, to get buoyant budget forecasts out of the rival Congressional Budget Office, which is more independent than the OMB, a more extreme strategy was required. Elected officials hard wired misleading projections by excising from current law expensive policies that they had every intention of pursuing.

For example, the wars in Afghanistan and Iraq were financed with “supplemental” budget requests each year, as if they were a surprise. Likewise, every year, Congress canceled “planned” cuts in payments to physicians that, if ever implemented, would drive doctors out of the Medicare system. On the revenue side, the tax cuts that were enacted in 2001 were all extended into last year and this year, despite an expiry date of 2010; those who proposed the law never intended to allow it to expire.

Unrealistic macroeconomic assumptions, far-fetched theories about tax cuts and legislation that deliberately misrepresented policy plans all worked as intended, yielding overly optimistic forecasts, which in turn help to explain excessive budget deficits. In particular, such forecasts explain the failure to run surpluses during the economic expansion from 2002-2007: If growth is projected to last indefinitely, retrenchment is deemed unnecessary.

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