March 23, 2009
The CBOs budget projections released last Friday are based in part on our economic forecast. In this blog entry, I want to discuss how our projection of real (that is, inflation-adjusted) GDP, one of the most important economic factors in the budget projections, compares with two other forecaststhe Blue Chip forecast (an average of about 50 private-sector forecasters), and the Administration's forecast.
Often, it is useful to focus on growth rates, as we did in our report here. However, the effect of GDP projections on the budgetand especially on tax revenuecan be seen more clearly by comparing levels of projected GDP. As the figure below shows:
- CBOs projection of real GDP is lower than that of the Administration throughout the next 10 years, and,
- CBOs projection is stronger than the Blue Chip consensus of private forecasters in 2010 and beyond (although slightly weaker in 2009). A difference remains even though CBOs projection of growth slows a bit after 2015 (the slope of the line flattens slightly), while the Blue Chips projection does not.
Comparison of CBO, Administration, and Blue Chip Medium-Term Projections: Levels of Real GDP, 2005 to 2019
(Billions of 2000 dollars)
Sources: Congressional Budget Office; Office of Management and Budget; Department of Commerce, Bureau of Economic Analysis; and Aspen Publishers, Inc., Blue Chip Economic Indicators (March 10, 2009).
For the differences in 2009, much of the story is behind us: real GDP fell at an annual rate of 6.2 percent in the fourth quarter of 2008 and now seems likely to be falling at a similar rate in the first quarter of this year. CBOs forecast was completed a month and a half after the Administrations forecast and a few weeks after the March Blue Chip survey. Economic news during that timeweaker employment, exports, and orders for manufacturers, and downward revisions to GDP growth in the fourth quarter of 2008 and to employment growth in December and Januarycaused many economists to sharply reduce their estimates for the level of economic activity in the first part of this year.
But, like the Blue Chip consensus, CBO projects the beginning of an upturn late this year (as shown in the figure below), reflecting in part the effects of the recent economic stimulus legislation (the American Recovery and Reinvestment Act) and very aggressive actions by the Fed and the Treasury.
The Gap Between Actual and Potential Output (Percentage of potential GDP)
Note: The gap is the difference between real (inflation-adjusted) gross domestic product and its estimated potential level (which corresponds to a high level of resourcelabor and capitaluse).
Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.
For the next few years, CBO projects faster growth than the Blue Chip, as the economy grows back toward CBOs estimate of potential GDP (which corresponds to a high level of use of labor and capital resources). Still, the CBO forecast assumes that the gap between actual and potential output closes more slowly than in previous recoveries because of a persistent drag from financial markets, households loss of wealth, the overhang of vacant houses, and weak economic growth overseas. Therefore, CBO projects that the economy does not return to its potential level until 2014.
In the 2015-2019 period, the projected rate of real GDP growth averages 2.4 percent. That rate is lower than during the period from 2010 to 2014, largely because there is no longer any gap to close between actual and potential GDP.
Projected growth from 2015 to 2019 is also below historical average growth rates, a difference that is more than accounted for by slower growth in the labor force because of the retirement of the baby boom generation. Over the postwar period, the labor force grew at an average annual rate of 1.6 percent; by contrast, we project it to grow only 0.4 percent per year in the period from 2015 through 2019. As a result, potential GDP grew 3.4 percent per year on average in the postwar period, but CBO expects that it will grow by only 2.4 percent annually (allowing for a tad more productivity growth) in the 2015-2019 period. That demographic trend is reflected also in the Social Security Administrations projections of the labor force, available here. CBO published its own analysis of demographic trends; while the numbers have changed a little with new information since then, the general story remains the same.
To be sure, all economic forecasts are subject to considerable uncertainty, as we emphasized in our report. But I hope that this discussion of the logic behind the latest CBO forecast is helpful to readers of that report.