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 an important point: 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 cost of unemployment benefits and food stamps rise. Add the two together, and rising 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 Sates, 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 twelve 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 contributorMorgan Houseldoesn'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 insightsmakes us better investors. The Motley Fool has a disclosure policy.

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