The Biggest Threat to Deficits

Earlier this year, Rep. Paul Ryan released a budget proposal offering a best-of-both-worlds promise: Taxes can be cut and the budget can be balanced without massive, immediate spending cuts.

How? Assume the unemployment rate will fall to 2.8%, and effectively stay there forever.

The awkward assumption turned heads, but it also highlighted two important points: A forecast can say whatever you want it to if you use the right assumptions, and the unemployment rate is one of the most important variables in any budget forecast.

"Why" is simple. When unemployment rises, tax revenue falls as fewer workers pay income taxes and business profits drop. Spending also jumps as the costs of unemployment benefits and food stamps rise. Add the two together, and increasing unemployment has been one of the largest contributors to the yawning federal budget deficit in recent years. When comparing 2007's budget deficit with today's figures, roughly half of the increase comes from lower tax revenue and higher unemployment benefits. It's a big deal.

And think about it: If unemployment has been one of the biggest factors affecting the budget deficit over the past few years, it will undoubtedly be one of the biggest factors over the coming years.

That's where things could get hairy. The budget-deficit forecasts over the next 10 years are bad enough: The nonpartisan Congressional Budget Office projects a cumulative deficit of about $7 trillion over the next decade.

But that projection assumes the unemployment rate will fall to around 5% by 2015 and stay there for the rest of the decade. Sure, that could happen. But it's not hard to make the case that unemployment may stay much higher (more on that in a second). If it does, throw current forecasts out the window. Future deficits will be astronomically higher than now expected.

The CBO used to calculate the effect a 1% change in unemployment could have on budget deficits, but it stopped about a decade ago when deficits turned into surpluses (the focus then became how to spend more and take in less, in contrast to today). Adjusting those old estimates to account for today's larger economy, you get a very rough, frightening, estimate: Every 1% increase in the unemployment rate could add about $200 billion a year to the budget deficit. Over a decade, we're talking trillions of dollars.

Here's another way to think about it: At current estimates, the CBO assumes that tax revenue as a percentage of GDP will equal about 20% in 2015, up from about 15% today. That 5% increase is based almost entirely on the idea that unemployment will fall dramatically. If it doesn't, every 1 percentage point they're off by adds $180 billion a year to deficits. Tack on the same amount for higher unemployment benefits.

Bottom line: A crude, back-of-the-envelope calculation shows that if unemployment averages 7% between 2012 and 2021 -- instead of the 5.2% currently projected -- the budget deficit could be $2 trillion to $4 trillion higher than now envisioned.

Why might unemployment stay that high? The economy is awful, for one, and the history of post-financial-crisis recessions shows it tends to stay awful for years as consumers and businesses pay down debt.

But it's much more than that. The 5% unemployment figure the CBO predicts we will revert to is in line with what used to be our economy's "natural" unemployment rate, or the highest employment can get before inflation ramps up enough to spark a recession. When things improve, the unemployment rate usually gravitates toward 5% -- likely why the CBO picked the number.

But there's good reason to believe that the scars of the past three years have pushed that natural unemployment higher. Wharton professor Justin Wolfers recently noted that, in Europe, high unemployment tends to stick around for a generation. In America, it's typically been a short-term phenomenon. Why the difference? He explained:

"Typically in the United States, if you're unemployed you're unemployed for three months. You get back to work. You didn't lose many skills. In Europe, folks are unemployed for a year, two years.

"Today in the United States, people are starting to get unemployed six months and 12 months. They're losing contact with the world of work. And so the problem is that, even when the economy comes back, it's not clear that these folks are necessarily going to be in contact with the labor market, able to pick up jobs even when the economy generates them. ...

"I'm terrified that if we leave millions of people out there decreasingly engaged with the world of work, structural unemployment may become an American problem in ways it has been a European problem."

More than 6 million Americans have been out of work for six months or longer -- by far the largest proportion since the Great Depression. The longer these folks remain unemployed, the harder it will be for them to regain employment even when jobs return. Skills atrophy, potential employers look down on you, and morale drops to a point of hopelessness. Add to this that tomorrow's jobs increasingly require specialized skills, and a flatter world means competition for jobs transcends continents, and the employment future for millions of Americans is truly dreadful. Edmund Phelps, who won a Nobel Prize in economics, thinks the new natural rate of unemployment is closer to 7.5% than the old 5%.

Most deficit discussion centers around the fact that the current projections are bad, and we need to take steps to make them better. That might be the wrong perspective. The projections are bad, and the top priority might be ensuring they don't get worse. Anyone in Washington serious about deficits over the next 10 years would focus on one thing and one thing only: jobs.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On September 20, 2011, at 6:20 PM, xetn wrote:

    I think it is very sad that we have so many people on long-term unemployment and maybe an equal number that have given up or have taken part-time work instead. There are many people with advanced degrees that are serving up Starbucks and doing other less demanding tasks. I am not saying that serving Starbucks order is not important, just that someone with an MBA is not needed for the job.

    I think we as a country have made some bad choices in dealing with unemployment: extending benefits, raising minimum wages etc. Not hinting that they are in any way responsible for the current problems; but both have been shown to reduce either the ability or the incentive for obtaining gainful employment.

    Government has about fired all of its "generate jobs" bullets and have been shooting blanks for some time now. This in spite of all the "green shoots" that never appeared. So, in keeping with Einstein's definition of insanity: "if you keep doing the same thing over and over and expecting a different result".. We need a complete revision of this process. Government is not good a "creating jobs" unless it is hiring a government employee, which in essence is what unemployment comp is.

    I don't have a panacea, but we could eliminante the requirement for business licenses (many people would maybe start a small business: maybe many are but under the radar). We could eliminate the minimum-wage law and give unexperienced people a chance to gain work experience. Eliminating much of the burdening government regulations that really are designed to prevent competition, etc. Just some examples. Try to think of some your selves.

    The key is: businesses do not hire someone because of a tax break; they hire someone because they expect to earn at least more than the employee costs from that employee's efforts. If there is not economic benefit, it is stupid to hire anyone.

  • Report this Comment On September 21, 2011, at 11:07 AM, astuber9 wrote:

    I recently saw how much we are spending on income security or unemployment and was shocked by the number. This article highlights several reasons why it is so important to get people back to work and avoid long term unemployment. I think it is very clear that we need to stop subsidizing unemployment and force these people to take the low paying jobs that are available. I think we all know people (I know a lot) that are just being lazy and would rather take umemployment than work for only 5% or so more pay than unemployment. I'm guessing Morgan disagrees and believes stimulus is the answer. I think both are required at this point. Let's build roads and take away benefits.

  • Report this Comment On September 21, 2011, at 11:14 AM, slpmn wrote:

    Xetn - good points, I agree with many of them. However, I am skeptical that reducing/eliminating regulations is going to spur job creation, at least the desireable kind. Do we really want to kickstart job growth by hiring people at $1/hr or lowering the cost of pollution? Seems to me like our problems are fundamental in nature. We are in the midst of a massive deleveraging and it will take time to work through it. Stimulus, whether it's in the form of cheap money, tax cuts, or deregulation, is like injecting nitrous oxide into a car's engine. You get a short term boost, but at the cost of potential long term damage. Maybe its time to step back and just let this damn recession run it's course. I'm done with stimulus, whether it comes from the left in the form of higher spending or the right in the form of deregulation. It would be nice to see a recovery that is based on fundamental strength of industry for once, not a series of short sighted panic moves by politicians.

  • Report this Comment On September 21, 2011, at 11:51 AM, AllAltitude wrote:

    "It would be nice to see a recovery that is based on fundamental strength of industry for once, not a series of short sighted panic moves by politicians."

    I couldn’t agree more. It seems like everyone is holding their breath, waiting for the government to come up with a magic formula that will reverse this recession. I don’t believe that will happen regardless of who’s in office or the policy changes they institute.

  • Report this Comment On September 21, 2011, at 12:11 PM, 1Douggie wrote:

    Is this the new normal? Not being an economist I am making an asumption here; a service sector economy probably cannot produce a whole lot of plentiful high paying jobs, unless you are in the smoke and mirrors ponzi banking business where the main job is stealing the folks' money. Therefore, the deficits continue until they (the uber rich elitie who control everything anyhow) hit the reset button where a new world currency erases the excesses of a make-believe banking system backed by nothing. Things do not look very rosey from my perspective....

  • Report this Comment On September 21, 2011, at 12:29 PM, islandertrader07 wrote:

    I agree with astuber9. we have major infastructure problems that need to be addressed. we have extremely high unemployment in construction. why not offer tax breaks to constru/industrial companies to hire new employees. even further, why not let reveune genereated by a US infastructe project be taxed at, say 15%?? companies are creating jobs, people are being productive, and they get to keep more of their hard earned money.

    i understand that taxes are the price of living in civilized society, but its a simple equation. if you spend more than you make, your going to go broke. cut benefits (forcing people to become self-reliant again), and cut taxes (allowing people to keep more of their hard earned income).

  • Report this Comment On September 21, 2011, at 12:31 PM, islandertrader07 wrote:

    *forgot to add this*

    after cuts to benefits and taxes, the rest will take care of itself.

  • Report this Comment On September 21, 2011, at 1:03 PM, plange01 wrote:

    the biggest threat to america's survival at this point is not acting fast enough to remove obama from office...

  • Report this Comment On September 21, 2011, at 1:08 PM, 1Douggie wrote:

    That's a big 10-4 plange01

  • Report this Comment On September 21, 2011, at 2:28 PM, Tygered wrote:

    Another excellent article Morgan.

  • Report this Comment On September 21, 2011, at 4:34 PM, Harker207 wrote:

    The biggest threat to America, plange01 and 1Douggie are obstructionists in Congress who are more interested in fighting the President than actually fixing things. These are inherited problems from a Republican administration and we need to work together instead of preventing policy initiatives from taking off because of partisan politics.

  • Report this Comment On September 21, 2011, at 4:59 PM, 1Douggie wrote:

    I am sorry Harker207, don't blame the GOP soley. The Dems had control of of the legislative & executive branches of our government for two years and what did they accomplish other than spend us into oblivion? No budgets, no fiscal responsibility, just spending- bloat the size of government more. I know, this all started back in Regans era or and both parties have plenty of blood on their hands however it all really began with FDR. The problem is there is NO fix.... As I said previously, the fiat currency system we and other nations have had in place for years is nothing more than kicking cans down roads until the there is no more road. We are just about at the end of the road. It is dependant upon the average guy running on debt and low savings (watch some of Michael Maloney's videos on UTube on how the FED & US Treasury operate) Ron Paul has been preaching out of control government spending for years and is labeled a nut. Alas, pray that everyone gets poor peacefully.

  • Report this Comment On September 22, 2011, at 9:40 PM, skypilot2005 wrote:

    On September 21, 2011, at 4:34 PM, Harker207 wrote:

    "The biggest threat to America, plange01 and 1Douggie are obstructionists in Congress who are more interested in fighting the President than actually fixing things. "

    The first two years of President Obama's administration his party controlled BOTH houses of Congress.

    Hmmm

    Seems it's "Still Bush's fault...." or "obstructionists in Congress"....

    I wonder what the next excuse will be.

    It's time to for the President to "man up" and take responsibility for his choice of advisers the last 3 years.

    Sky Pilot

  • Report this Comment On September 23, 2011, at 1:45 AM, CaptainWidget wrote:

    Length of unemployment increased at the same time the length of unemployment benefits increased. Europe average long periods of unemployment benefits, and they also average long periods of unemployment in their citizens. Denmark previously had 4 years worth of unemployment benefits, with the sharpest drop off of beneficiaries right before the end of the 5 year mark. When they changed it to 4 years, the sharpest drop off came right before the 4 year mark...

    It's almost as if there's some sort of weak, causal relationship between the two. It's almost as if......if you pay people to be unemployed, they'll stay unemployed.....strange indeed.....

  • Report this Comment On September 24, 2011, at 7:39 PM, wolfman225 wrote:

    They have found the same here. When the standard term of UE benefits was 13 weeks (with a one-time extension to 26 weeks) they found a great increase in job search activity, as well as an increase in the number of people gaining employment when the recipients were within 7-10 days of exhausting benefits.

    Yeah, it sucks to have to take a job that pays less, sometimes much less, than the job you had (or the dream job you've been holding out for). Get over it. Real men (and women) do whatever is necessary to provide for themselves and their children. They don't lay around on the couch or hang out on the corner bitching about how unfair the "rich" are while they check the mail every week for the benefits the "rich" are providing them with.

  • Report this Comment On September 25, 2011, at 10:27 AM, devoish wrote:

    Morgan

    http://blogs.alternet.org/oleoleolson/2010/08/05/massive-cen...

    Where are they now?

    Best wishes,

    Steven

  • Report this Comment On September 25, 2011, at 8:52 PM, macroecon200 wrote:

    2 things - - 1) massive macro economic leakage (imported energy and consumer goods plus job outsourcing and foreign military spending) and 2) massive importation of labor (40 million legal immigrants over the last 3 decades, 10 million plus illegals and millions more on work visas.) This is the way the monopolized big business sector wants it, and they control the government through bribery and intimidation. If you don't understand these basics you really don't have a clue.

  • Report this Comment On September 26, 2011, at 4:35 PM, DJDynamicNC wrote:

    Please do not confuse economic moralizing with economic pragmatism.

    Saying "real men do whatever it takes" is not economic policy, it's just economic machismo. You can believe that if you like, but a functioning modern society needs to be effective, not waste time making moral judgments based on one's own taste of macho bravado. "Man up, loser" is not a plan for a modern economy.

  • Report this Comment On September 26, 2011, at 4:37 PM, DJDynamicNC wrote:

    To address the unemployment benefits concern - I agree that there is a correlation between unemployment benefits and remaining unemployed (there's a fair bit of evidence to that effect, and it also makes logical sense).

    Instead of unemployment, then, how about we simply offer everyone a job who wants one? There is plenty of work that needs doing around this place. If the government is providing a job instead of just providing a check, then we're getting bang for our buck, we're putting people back to work, and we were already spending the money on people sitting around anyway.

  • Report this Comment On September 27, 2011, at 11:04 AM, astuber9 wrote:

    DJDynamic,

    "Instead of unemployment, then, how about we simply offer everyone a job who wants one? There is plenty of work that needs doing around this place"

    I agree with some stimulus, but the taxpayers are paying for more than just the labor. If we pay for more infrastructure for example, you also have to pay for equipment/materials/contractor's profit. Nothing is free.

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