By Olivier Garret, CEO, Casey Research

On March 20, 2009, the bipartisan Congressional Budget Office (CBO) released its latest forecast in an effort to take into account the impact of the recently released Obama budget. The verdict? A whopping $1.8 trillion deficit for 2009, approximately four times larger than the all-time record established in 2008 ($455 billion).

The concerns raised by this latest forecast are many:

1) A mere two months ago, the CBO’s estimate for 2009 was “only” $1.2 trillion. They have already grossly underestimated a deficit that will most likely continue to balloon in the coming months. While the new administration

2) has focused its attention on the spending side of the budget, it has paid little attention to the other side of the equation. What will happen when tax revenue comes in much lower than current projections?

3) Even ignoring the likely expansion of the projected deficit, where will we get the $1.8 trillion needed to cover the CBO’s estimated deficit? Foreign investors? Higher taxes? Or that old standby, the printing presses?

Buried in the latest CBO forecast are numerous reasons to be alarmed, chief among them the authors’ admission that they have no idea what the future holds for the economy. They state:

“Both the magnitude of the contractionary forces operating in the economy and the magnitude of the government’s actions to stabilize the financial system and stimulate economic growth are outside the range of recent experience. The forecast assumes that financial markets will begin to function more normally and that the housing market will stabilize by early next year. The possibility that financial markets might not stabilize represents a major source of downside risk to the forecast. ”

To cover themselves when their forecasts fall flat, the CBO members offer the following caveats:

“Households’ and businesses’ confidence is also difficult to predict.”

and

“CBO’s forecast incorporates the middle of the range of the agency’s estimates of ARRA’s impact on GDP and employment, that range is quite large.”

These statements are somewhat disconcerting when we remember that in January 2008, it was this same CBO that predicted the U.S. government’s fiscal year deficit would be $250 billion. What did we end up with? A $455 billion deficit. They weren’t even close.

What also worries us is that while the CBO clearly states that its forecast includes the impact of the currently approved programs, it fails to take into account any further bailouts of various industries, any new stimulus packages, or any additional programs proposed by the administration.

While the current CBO forecast is the result of very scientific economic models put together by a multitude of experts, our economists at Casey Research question many of its basic assumptions by applying the same logic that allowed us – more than three years ago -- to correctly predict the subprime crisis and its expansion into a widespread financial disaster. We knew then that the models supporting the valuation of many derivatives were flawed, even as other analysts were claiming that real estate values were never going to decline and that securitization of subprime mortgages could magically eliminate default risk.

Applying this basic logic, let’s look at some of the core assumptions in the CBO forecast:

The Consumer Price Index is expected to drop from +3.8% in 2008 to -0.7% in 2009 (good news), while unemployment is projected to grow from 5.8% in 2008 to 8.8% in 2009 (it could be worse). The cost of borrowing record amounts of money will decline from 1.4% to 0.3% for the 3-month T-bill and from 3.7% to 2.9% for the 10-year T-bond (convenient).

In The Casey Report our Chief Economist Bud Conrad compared data from the current recession with those of serious crises in the past. His conclusions? Although the impact of the current financial turmoil has been serious, we are nowhere near the average bottom experienced in other serious recessions.

The unemployment rate is expected to bottom at 8.8% in 2009 (we are almost there), only two years after the start of the current recession. Unfortunately, history tells us that these forecasts may be far too optimistic. Looking at trends of the past, on average, unemployment peaked about four years after the start of a serious recession. In the worst case, the peak occurred 11 years after the start of the decline.

In addition, a rate of 8.8 % unemployment would look pretty good if compared to the figures in past crises. Historically, the average bottom was reached at 11%, while the worst-case scenario saw 27% unemployed.

Currently, Gross Domestic Product has only contracted by 1.5% (conveniently, the CBO estimates the GDP’s contraction to bottom at precisely 1.5% in 2009 before expanding again in 2010). What does history tell us? In previous recessions, the GDP dropped by 9.3% on average and by 28% in the worst case.

Based on its projected 1.5% reduction in the GDP, the CBO estimates that tax revenue will fall by as much as 13.4% (with part of this decline due to planned tax reductions for lower-income Americans). A more realistic, 5% reduction in GDP could have a far greater impact on revenue and cause a significant increase in the deficit.