Why do so many countries so often wander far off the path of fiscal responsibility? Concern about budget deficits has become a burning political issue in the United States, has helped persuade the United Kingdom 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 a one 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. But another factor has attracted insufficient 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 2001-2007, for example, the US government made optimistic budget forecasts at each stage. These forecasts supported enacting big long-term tax cuts and accelerating growth in spending (both military and domestic). European countries behaved similarly, running up ever-higher debts. Predictably, when global recession hit in 2008, most countries had little or no “fiscal space” to implement countercyclical policy.
In most cases, the problems have long been plain for objective observers to see, but public officials kept their heads buried in the sand. Over the period 1986-2009, the bias in official U.S. deficit forecasts averaged 0.4 % of GDP at the one-year horizon, 1% at two years, and 3.1% at three years. Forecasting errors were particularly damaging during the past decade. The U.S. government in 2001-03, for example, was able to enact large tax cuts and accelerated spending measures by forecasting that budget surpluses would remain strong. The Office of Management and Budget long turned out optimistic budget forecasts, no matter how many times it was proven wrong. For eight years, it never stopped forecasting that the budget would return to surplus by 2011, even though virtually every independent forecast showed that deficits would continue into the new decade unabated.
How were American officials in the last decade able to make forecasts that departed so far from subsequent reality? In three sorts of ways. The first comes in the form of optimistic baseline macroeconomic assumptions such as a high and everlasting growth rate. OMB forecasts of economic growth were biased upward: by a huge 3.8% at the three-year horizon.
Second, some politicians argued that tax cuts were consistent with fiscal discipline by appealing to two fanciful theories: the Laffer Proposition, which says that cuts in tax rates will pay for themselves via higher economic activity, and the Starve the Beast Hypothesis, which says that tax cuts will increase the budget deficit but that this will put downward pressure on federal spending.
Sanguine macroeconomic assumptions will do the job in the context of OMB forecasts and fanciful theories about the effects of tax cuts can deliver the rosy scenarios of presidential speeches. But to get optimistic fiscal forecasts out of the Congressional Budget Office a third, more extreme, strategy was required. (In 2003, when some Lafferite congressmen tried to get CBO to say that “dynamic scoring” of the effects of tax rate cuts would show higher revenue, the estimates from the independent agency did not give the answer they wanted.)
To understand the third strategy, begin with the requirement that CBO’s baseline forecasts must take their tax and spending assumptions from current law. Elected officials in the last decade therefore hard-wired over-optimistic budget forecasts from CBO by excising from current law expensive policies that they had every intention of pursuing in the future. Often they were explicit about the difference between their intended future policies and the legislation that they wrote down.
Four examples: (i) the continuation of wars in Afghanistan and Iraq (which were paid for with “supplemental” budget requests when the time came, as if they were an unpredictable surprise); (ii) annual revocation of purported cuts in payments to doctors that would have driven them out of Medicare if ever allowed to go into effect; (iii) annual patches for the Alternative Minimum Tax (which otherwise threatened to expose millions of middle class families to taxes that had never been intended to apply to them); and (iv) the intended extension in 2011 of the income tax cuts and estate tax abolition that were legislated in 2001 with a sunset provision for 2010, which most lawmakers knew would be difficult to sustain. All four are examples of expensive policy measures that Congress fully intended would take place, but that it excluded from legislation so that the official forecasts would misleadingly appear to show smaller deficits and a return to surplus after 2010.
Unrealistic macroeconomic assumptions, fanciful theories about tax cuts, and legislation that deliberately misrepresented policy plans all worked as intended, yielding over-optimistic forecasts. These in turn help to explain excessive budget deficits. In particular, they explain the failure to run surpluses during the economic expansion from 2002-2007: if growth is projected to last indefinitely, retrenchment is regarded as unnecessary.
Many have suggested that budget woes can best be held in check through fiscal-policy rules such as deficit or debt caps. Some countries have already enacted laws along these lines. The most important and well-known example is the eurozone’s fiscal rules, which supposedly limit budget deficits to 3% of GDP and public debt to 60% of GDP for countries to join. The European Union’s Stability and Growth Pact (SGP) dictated that member countries must continue to meet the criteria. We have now seen how well that worked out.
Other countries have also adopted fiscal rules, most of which fail. Switzerland’s structural budget rule (”debt brake”) is well-designed to allow higher deficits in recessions automatically, counterbalanced by surpluses in expansion periods. But the success of any budget rule depends on accurate forecasts of government spending and revenues. Getting those forecasts right has proven to be difficult for most countries.
Part of the problem is that governments that are subject to budget rules, such as Europe’s SGP, put out official forecasts that are even more biased than the US or other countries. The Greek government, for example, in 2000 projected that its fiscal deficit would shrink below 2% of GDP one year in the future and below 1% of GDP two years into the future, and that the fiscal balance would swing to surplus three years into the future. The actual balance was a deficit of 4-5% of GDP - well above the EU’s 3%-of-GDP ceiling.
In almost all industrialized countries, official forecasts have an upward bias, which is stronger at longer horizons. On average, the gap between the projected budget balance and the realized balance among a set of 33 countries is 0.2% of GDP at the one-year horizon, 0.8 % at the two-year horizon, and 1.5 % at the three-year horizon. So, how can governments’ tendency to satisfy fiscal targets by wishful thinking be overcome? In 2000, Chile created structural budget institutions that may have solved the problem. Independent expert panels, insulated from political pressures, are responsible for estimating the long-run trends that determine whether a given deficit is deemed structural or cyclical.
The result is that, unlike in most industrialized countries, Chile’s official forecasts of growth and fiscal performance have not been overly optimistic, even in booms. The ultimate demonstration of the success of the country’s fiscal institutions: unlike many countries in the North, Chile took advantage of the 2002-2007 expansion to run substantial budget surpluses, which enabled it to loosen fiscal policy in the 2008-2009 recession. Perhaps other countries should follow its lead.
[A shorter version of this op-ed was published by Project Syndicate. It draws on several recent academic publications of mine, especially "Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Oxford Review of Economic Policy 27, no.4, 2011, 536-562.]