Jack Lew on the Deficit and the 2012 Fed Budget Overview

President Obama is about to deliver his budget proposal to Congress and Jack Lew, OMB Director, appears in the video above to explain how the administration plans to get the deficit under control. In a prior post (here), I looked specifically at the deficit (the topic of Jack Lew's first white-board presentation) and deficit dynamics.

Mr. Lew goes on, in the second white-board exercise, to talk about the debt/GDP ratio. When the Obama administration took office, it was high (approaching ten percent). The intention of the budget that is about to be unveiled is to bring it down to around two percent of GDP.

Looking at the US budget deficit as a percent of GDP from 1900 to the present (above) it's clear that the major World Wars created deficits far larger than either the Great Depression, the Vietnam War period or the current Great Recession. In any event. Mr. Lew expects the deficit to decline to historically sustainable levels in the future.

Essentially, Mr. Lew has a business-as-usual (BAU) model in mind when making his deficit forecasts. The BAU forecast above suggests that a more reasonable GDP percentage for the deficit might be around three percent (somewhere between two and four percent). Mr Lew's forecast is at the lower end based on historical data and political calculation.

What's also somewhat interesting about the graph above is the comparisons of actual deficits (the black line) with the dynamic attractor (red dashed line) and the 98% prediction intervals. The period from 1950-1975 had improbably low deficits (if deficit hawks want to point back to this period, they'd be cherry-picking the data). Also, the Clinton surplus period around 2000 (Jack Lew was director of OMB in 2001!) was an improbable surplus given historical experience (Democrats would be cherry-picking the data to point to this period in defense of their ability to generate surpluses or control expenditures). The current deficit is quite improbable given experience since 1950 but not, as we saw above, given the entire Long Twentieth Century.

Mr. Lew's BAU model, however, might not be the best way to actually forecast the deficit. The forecast above predicts the US deficit as a percentage of GDP using trends in the state of the U.S. Economy. The forecast uses the USL20 model. The model predicts that as a result of economic performance (particularly the effects of globalization), deficits will increase in the future regardless of what Democratic or Republican administrations might attempt to do about it.

For me, these forecasts provide a counter point to Mr. Lew's optimistic, business-as-usual scenarios.

IN THEORY, you might expect the US Federal deficit to be a random walk, D(t+1) = D(t) + V, where this years deficit depends on last year's deficit and any economic shocks that might necessitate deficit spending or debt retirement. Or, a business as usual model for the deficit might be D(t+1) = a + b D(t) + V where the coefficient b captures some inertia in retiring debt and a=0 meaning that the average debt should be zero in the long-run. One last idea would be that the deficit should related to the state of the US economy, D(t) = a + b D(t-1) + cS(t-1) + V. That is, the deficit should respond to secular and cyclical trends in the economy.