Monday, August 08, 2011

Getting to the bottom of the $2 trillion mistake.

Standard & Poor's downgraded the US to a AA+ rating over the weekend. The Treasury Department immediately fired back that Standard & Poor's analysis was based on a $2 trillion mistake. There are pretty smart people running Standard & Poor's but they are fallible. So ok, what sort of mistake?

From the Treasury:
Specifically, CBO calculated that the Budget Control Act, including its discretionary caps, would save $2.1 trillion relative to a “baseline” in which current discretionary funding levels grow with inflation.

S&P incorrectly added that same $2.1 trillion in deficit reduction to an entirely different “baseline” where discretionary funding levels grow with nominal GDP over the next 10 years. Relative to this alternative “baseline,” the Budget Control Act will save more than $4 trillion over ten years – or over $2 trillion more than S&P calculated. (The baseline in which discretionary spending grows with nominal GDP is substantially higher because CBO assumes that nominal GDP grows by just under 5 percent a year on average, while inflation is around 2.5 percent a year on average.

Entirely different baseline? What the hell? How do you get a second baseline? Well, the Treasury Department doesn't want to say. That makes me suspicious. What does Standard & Poor's have to say about this? (Stupid Flash. Sorry, for not linking directly, but if you go to there's a press release called "S&P Clarifies Assumption Used On Discretionary Spending Growth" currently on the main page).

We used the Alternative Fiscal Scenario of the nonpartisan Congressional Budget Office (CBO), which
includes an assumption that government discretionary appropriations will grow at the same rate as nominal

There's your second baseline. Standard & Poor's took the savings estimated from the debt deal which was based on the CBO's Baseline and applied it to the Alternative Fiscal Scenario. But why even look at the Alternative Fiscal Scenario? What is the difference between the two?

Time to ask the CBO directly:
The budget outlook is much bleaker under the alternative
fiscal scenario, which incorporates several changes to current
law that are widely expected to occur or that would
modify some provisions of law that might be difficult to
sustain for a long period. In this scenario, CBO assumed
that Medicare’s payment rates for physicians would gradually
increase (which would not happen under current
law) and that several policies enacted in the recent health
care legislation that would restrain growth in health care
spending would not continue in effect after 2020. In
addition, under the alternative scenario, spending on
activities other than the major mandatory health care
programs, Social Security, and interest would fall below
the average level of the past 40 years relative to GDP,
though not as low as under the extended-baseline scenario.
More important, CBO assumed for this scenario
that most of the provisions of the 2001 and 2003 tax cuts
would be extended, that the reach of the alternative minimum
tax would be kept close to its historical extent, and
that over the longer run, tax law would evolve further so
that revenues would remain at about 19 percent of GDP,
near their historical average.

There are some odds and ends the CBO deems likely but aren't actual law yet. The linchpin of these arguments is that the Bush tax cuts will be extended. I think it's fair of Standard & Poor's to assume the Alternative Fiscal Scenario is closer to reality, but the Treasury Department was correct. It is absolutely a mistake to apply savings from the debt deal which were projected under the CBO's standard baseline to the Alternative Scenario. The CBO didn't calculate savings based on the Alternative so if S&P believes that baseline to be the more accurate one, they would need to do their own calculations.

Instead, S&P admitted their mistake and went with the standard CBO baseline. Good catch by the Treasury Department. Even if I can understand S&P's reasoning, you can't switch baselines like that. A final point on the mistake was that it wasn't a $2 trillion mistake as far as S&P was concerned. That $2 trillion is based on a 10-year projection. S&P deals with 3-5 year projections. It was a $345 billion mistake.

It didn't change anything. S&P still downgraded the US. You can discuss the whys of that decision if you want. This post was mainly to get to the bottom of this mistake business since it was so widely reported yet so poorly defined.


Cousin Pat from Georgia said...

"[S]o widely reported yet so poorly defined."

I'm shocked, SHOCKED that important political or economic information might be widely reported yet poorly defined considering the current media climate in America.

Dante said...

I was shocked that NOBODY bothered to be thorough. Usually, you can find some single source that ties together all of the information I've covered here.

Cousin Pat from Georgia said...

One of the lead articles on Slate quoted the mistake, but in parentheses, pursuant to a larger point on the Debt Deal.

Cousin Pat from Georgia said...

Of course, it takes a $2Trillion dollar mistake to get Erik Erickson to defend the Obama White House.