Saturday, October 20, 2012

Are US households about to re-lever? That's the implication of CBO's latest forecast

The latest Congressional Budget Office (CBO) projection for the US economy and the agency's forecast for the trajectory of US budget deficit seem inconsistent with one another.

The CBO projects the US federal budget deficit to go from 7.3% in 2012 to 1.2% in 2015. That's an incredible rate of fiscal consolidation in just 3 years.

How is that possible? Surely such contraction in government spending and tax increases (a form of "fiscal cliff") should do some serious damage to the GDP growth. The CBO indeed projects that the US will undergo a recession in 2013 as a result of these cuts, but according to the agency, growth will accelerate from that point on. One year of pain and the problem is "solved". The projected average real growth for the 2014-2017 period is 4.3%!

In fact the CBO's base case scenario forecasts the US rapidly closing the so-called output gap (after 2013), with the "Potential GDP" based on the aggressive extrapolation from the bubble years (see discussion).

Source: CBO

How can this fiscal consolidation continue so rapidly after 2013 while the real GDP growth stays in the 4%-5% range? Haven't we learned anything from the Eurozone's experience?

According to the latest analysis by the Levy Economics Institute (h/t Kostas Kalevras), the only way this is possible is if the US private sector, particularly the consumer, goes on a massive borrowing spree - re-leveraging to levels not seen even during the bubble years.

US Private Sector Debt (Source: Levy Economics Institute)

Levy Economics Institute: - Given net exports and fiscal policy, if the economy has to reach the growth rates projected by the CBO, the gap in demand can only be filled by an increase in domestic investment and consumption fuelled by borrowing.
Given this analysis, there are really only two possibilities here:

1. The US consumer is getting ready to start borrowing unprecedented amounts. Thus far there has been absolutely no evidence of that. In fact various economic forecasts point to US households continuing to delever (see discussion).

2. The CBO's optimistic US GDP growth forecast is simply wrong.
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