Word Matching the “Deadly Sins”: #2

This is my second pass at the “Government Finances Word Match” in the diagram below.  If you missed the first article in the series, we’re matching seven “sins” in the right-hand column to the seven topics on the left. Individually, the topics may seem to be only modestly important.  But when they’re added together, I’ll show that they describe a dangerous gap between our true financial position and the false picture that policymakers seem to want you to believe.

In this article, I’ll offer my word match for “Unexpected Events.”

How to make the “unexpected” more tangible

Alongside its long-term budget forecasts, the Congressional Budget Office (CBO) offers the advice to expect the unexpected. It warns of unfortunate events that occur with some regularity, even though their timing isn’t known in advance. Here’s my record of the CBO’s concerns:

The CBO wants us to know that these risks aren’t reflected in its debt projections. And it’s right to warn us of the many ways its projections could be knocked off track. But the projections are numeric and tangible, while the warnings are vague and intangible. And no matter how many times they’re repeated, they’re still vague and intangible. Let’s see if we can make them more real.

My approach won’t be perfect but it’s easier than you may think. I’ve looked back three decades and simply added up the government’s unexpected spending, considering most of the setbacks listed in the table above. Here’s the data I used:

1. The net supplemental spending costs in the 89 laws enacted between 1981 and 2010 that contained either supplemental appropriations or rescissions (cancellations of prior appropriations). These can be found here, here, here and here.  Supplemental appropriations provide additional funding outside the normal budgeting process, allowing Congress to respond to unanticipated needs or priorities. Examples from the last three decades include the first Gulf War, the Iraq and Afghan Wars (until Obama added their costs to the annual appropriation process in 2010), a slew of natural disasters, a few terrorist attacks and various other types of unexpected spending.
2. The estimated effects of automatic stabilizers on the government’s annual budget balances. Automatic stabilizers are counter-cyclical changes in government finances triggered purely by the economy’s movement through the business cycle. They don’t include the costs of proactive stimulus measures. In other words, they represent the natural fiscal costs of recessions (and benefits of expansions).
3. The estimated costs of three stimulus packages intended to either forestall or lessen the effects of recessions: the American Recovery and Reinvestment Act (ARRA) of 2009, the Economic Stimulus Act of 2008, and a relatively small stimulus package that Bush 43 signed in 2002. Other forms of stimulus are ignored because they weren’t wholly temporary responses to recessions (for example, Reagan’s 1981 tax cuts and Bush’s 2001 tax cuts), or they were counted in supplemental appropriations that I had already considered.
4. The estimated costs of the savings and loan industry bailout and the Fannie Mae and Freddy Mac bailouts. Smaller bailouts and those that were mostly reimbursed are ignored. TARP is the most notable omission, especially as there are many reasons to distrust the government’s published figures for this program (see this article by Matt Taibbi, for example, or Neil Barofsky’s book.) But measuring its true costs would have required the kind of complex assumptions that I’m trying to avoid.

I calculated that unexpected events cost the government 1.1% of GDP per year for the period 1981 to 2010. Here’s the breakdown:

The next step is to ask the question: Is my historical estimate a reasonable benchmark for the future costs of unexpected events? I say yes, and the future could be worse. My answer is based partly on economic trends that I’ll discuss in the next article in this series. And it’s also based on the observation that things weren’t so bad in the last three decades. The economy was strong most of the time, such that automatic stabilizers actually reduced the deficit in ten years out of thirty. Only one recession – the big one from 2008 to mid-2009 – led to stimulus and bailout measures that had a meaningful effect on my calculations. Until that recession, the economy had been so stable that the time period came to be known as the Great Moderation.

What’s more, the last three decades didn’t include any of the four most expensive wars of the last 100 years: World War I, World War II, Korea and Vietnam. And my estimate excludes delayed costs of the wars that did occur, such as the veterans expenses that often exceed the initial costs of fighting a war.

Budget slippage and elephants

In my opinion, debt projections should include allowances for budget slippage of at least 1% of GDP. If you’re a perpetual optimist and prefer to think that budget plans never go off track, I suggest at least conducting a suitable stress test for unexpected spending. Call it a “high spending” scenario to leave room for a more hopeful (delusional?) base case.

To give some meaning to an allowance for budget slippage, I’ll compare the risk of unexpected spending to the current debate on long-term debt reduction. In the top panel of the table below, I’ve converted the cost figures shown above from GDP percentages to dollar amounts. In the bottom panel, I’ve included various CBO estimates for the deficit reduction associated with certain policy changes (according to this, this and this). And in both cases, I’m showing amounts for the year 2020 to be consistent with the CBO publication I used as a guide (the November 2012 document linked above).

If you’re familiar with today’s political debates, you know the measures in the table are all controversial, and that it would take tremendous compromises to enact more than a few of them. As of this writing, only one and a half have been implemented.  (The automatic BCA cuts went through almost entirely as planned, while Obama’s “rich people” thresholds were nearly doubled before the last decade’s tax cuts expired and after the CBO published these estimates.) What’s less understood is that the deficit reduction from just a few measures is offset by a simple repeat of the typical budgetary surprises of the last 30 years.

I’ll say it again differently: Once you recognize the inevitable budget slippage, it’s hard to imagine today’s cast of characters coming up with a debt reduction plan that even gets them back to where they started. I won’t call budget slippage the elephant in the room, since this particular room is full of elephants. Let’s just say it’s the elephant crap that gets swept under the carpet. (If you’ve never seen an elephant crap, you should add this to your bucket list – definitely my all-time, most memorable zoo experience.)

Calling all actuaries, accountants and risk managers

Again, my approach to measuring the problem is imperfect. A team of experts could do a better job estimating the future costs of unexpected events. The CBO’s modelers could do a better job blending the estimates into their projections. But these steps aren’t taken because many events are deemed too unpredictable to be estimated – an excuse that defies both collective knowledge and common practice. Actuaries, accountants and financial risk managers are all trained to place numeric estimates on unforeseen risks. Insurance premiums, credit loss provisions and investment decisions are all based on these numeric estimates.

The key is that any positive number is better than nothing. We can see the problem with nothing just by noticing that the debt debate almost never gets around to the risks of recessions, financial crises, wars, natural disasters, and so on. Political leaders and pundits habitually ignore the CBO’s warnings that these events will occur from time to time, relying instead on its incomplete projections. And for the omissions in these projections, I’ll match topic #2 to neglect.

Check back tomorrow for topic #3: Pension fund accounting.