    [Economic Outlook, Highlights from FY 1994 to FY 2001, FY 2002 Baseline Projections]
    [II.  The Turnaround in the Budget and the Economy]
    [From the U.S. Government Printing Office, www.gpo.gov]

    [[Page 13]]

                II.  THE TURNAROUND IN THE BUDGET AND THE ECONOMY

      This section reviews the budgetary and economic performance of the
    Clinton-Gore Administration, comparing conditions now with those when
    President Clinton took office. Over the past eight years, the budget has
    turned from record deficits to record surpluses; the resultant increase
    in national saving supported sharply rising investment, accelerating
    productivity, and the longest economic expansion in history. Moreover,
    the substantial improvement in the budget has set the Federal Government
    on a path to be debt-free by the end of this decade.

    The Clinton-Gore Economic Strategy

      President Clinton was elected with the goal of revitalizing the
    economy. When he took office in January 1993, the economy was slowly
    emerging from the 1990-1991 recession, with an unemployment rate of 7.5
    percent. He proposed a three-part economic strategy: fiscal discipline
    to free resources for private investment; increased support for
    investment in our people, including education, health care, and
    research; and engagement in the international economy, to open markets
    abroad to our products and services. In the last eight years, this
    Administration has completed hundreds of agreements that increase our
    access to foreign markets, and has expanded public human and
    infrastructure investment (as documented elsewhere in this volume).
    Furthermore, the Administration's new budget policy was enacted in 1993,
    and it has proven a great success.
      The budget deficit, which had reached a record $290 billion in 1992,
    has steadily fallen, until in 1998 there was a budget surplus for the
    first time in 29 years. The budget is projected to end the current
    fiscal year with a surplus of $256 billion--the fourth year in a row of
    surplus, for the longest period of budget surpluses since the 1920s; and
    by far the longest string of consecutive years of budget improvement in
    our Nation's history.
      The turnaround in the budget supported a remarkable turnaround in the
    economy. Financial markets responded to the shift from deficits to
    surpluses by reducing long-term interest rates. Real interest rates
    (actual market rates minus expected inflation) were about 1.2 percentage
    point lower on average under this Administration than they were during
    the previous 12 years. Lower real interest rates stimulated more
    business investment, leading to rising productivity, higher profits, and
    increased real wages. The average rate of economic growth accelerated to
    4.0 percent per year.
      The investment boom strengthened and prolonged the economic expansion,
    which by February 2000 had become the longest in U.S. history. This
    February, it will complete its tenth year. President Clinton is the
    first two-term President to leave office without enduring a recession.
    The past eight years were an extraordinary combination of low inflation,
    falling unemployment, soaring productivity, rising real wages, and
    declining poverty--which continued into the new millennium.

    Budgetary Performance

      Before 1993, 12 years of burgeoning budget deficits had quadrupled the
    amount of Federal debt held by the public--an increase of $2.3 trillion.
    Relative to the size of the economy, the debt almost doubled--rising
    from 26 percent of Gross Domestic Product (GDP) in 1980 to 48 percent in
    1992. The Administration's first priority was to cut the massive deficit
    (and thus slow the rise in Federal debt). To accomplish that, the
    Administration proposed, and the Congress enacted, the Omnibus Budget
    Reconciliation Act (OBRA) of 1993. It was a crucial step toward fiscal
    responsibility. The Administration expected OBRA to reduce the deficit
    significantly; but the actual improvement in the budget far exceeded
    these expectations. To finally eliminate the budget deficit, the
    President

    [[Page 14]]

    and the Congress agreed to the bipartisan Balanced Budget Act (BBA),
    enacted in 1997, which set a goal of a balanced budget by 2002. In 1998,
    the budget went into surplus four years ahead of schedule, accelerated
    by stronger-than-projected economic growth.

      Deficit Reduction Was Augmented by its Favorable Economic Effects: The
    cumulative results of OBRA and the BBA were a stunning turnaround. The
    Administration originally projected that OBRA would reduce the deficit
    by a cumulative $505 billion from 1994 through 1998. In fact, the total
    deficit reduction over this period was more than twice as large--$1.2
    trillion (and $3.3 trillion from 1993 through 2001) as long-term fiscal
    discipline proved its value by accelerating economic growth (see Chart
    II-1). As financial markets saw that the risk of exploding future
    deficits and Federal borrowing would truly decline, they brought market
    interest rates down--reducing the deficit directly, but more
    importantly, reducing the cost of capital to businesses, and stimulating
    investment and growth.

      Government Debt Was Reduced: When the Government runs a deficit, it
    borrows from the public and accumulates debt. The huge deficits incurred
    to pay for World War II pushed the publicly held Federal debt to a peak
    of 109 percent of GDP in 1946. For many years thereafter, the economy
    grew faster than the debt; and the ratio of the debt to the GDP
    gradually fell to a low of around 25 percent in the mid-1970s. The
    exploding deficits of the 1980s reversed this trend, and sent the debt
    back up--until it peaked at almost 50 percent of GDP in 1993. Had the
    Clinton-Gore Administration done nothing, both OMB and the Congressional
    Budget Office (CBO) had projected that publicly held Federal debt would
    have approached $7 trillion (or 75 percent of GDP) by 2002, and would
    have risen even further thereafter. Instead, the Administration's
    deficit reduction policy cut the ratio of debt to GDP immediately; and
    the budget surpluses

    [[Page 15]]

    since 1998 have actually reduced the dollar amount of debt, and driven
    the debt to GDP ratio down even faster. The ratio of publicly held debt
    to GDP in 2000 was 30 percentage points lower than was projected as of
    1993, based on the policies before the Administration's budget plan.
      Moreover, the pay-down in debt in the past three years ($363 billion)
    and the expected amount this year ($237 billion) combine to a $600
    billion debt reduction--the largest four-year debt pay-down ever. As
    Chart II-2 shows, this substantial reduction and the prospect of
    continuing surpluses have put the debt held by the public on a
    trajectory that can eliminate the Federal Government's debtor status by
    the end of this decade.

      There Are Now Unified, Social Security, and On-Budget Surpluses: The
    unified budget has been the most common framework for tallying the
    Federal Government's deficits and surpluses. The unified budget counts
    all Government receipts and spending (including Social Security
    contributions and benefits). This is the appropriate budget concept to
    evaluate how the Federal Government's activities affect the economy;
    obviously, for that purpose, it is essential to leave nothing out. The
    improvement in this overall budget surplus is shown in Chart II-1, and
    its effect on bringing down debt held by the public is shown in Chart
    II-2. Also, each of the major components of the unified budget is in
    surplus: the off-budget surplus--the excess of Social Security receipts
    over benefit payments, and the relatively small amount of transfers to
    or from the United States Postal Service--has increased from $45 billion
    to $158 billion between 1993 and 2001; and the on-budget balance--the
    rest of the unified budget--has swung from a $300 billion deficit to a
    $98 billion surplus (see Chart II-3). The Medicare surplus (which this
    Administration has proposed to move off-budget to protect that vital
    program's Trust Fund) has grown as well--from $4 billion in 1993 (and
    small

    [[Page 16]]

    deficits from 1995 through 1997) to $27 billion in 2001.
      A crucial part of the Clinton-Gore Administration's policy has been to
    save and protect the Social Security surpluses. The larger balances in
    the Social Security Trust Funds, and the interest that they earn, can
    finance Social Security benefits further into the future. Balances are
    currently invested in Federal securities--the most secure asset
    available. If Trust Fund assets were to be partly invested in private
    market instruments--such as stocks and bonds, rather than Federal debt--
    then the return earned by the Trust Fund could be somewhat higher, on
    average, over long periods. However, though the allocation of gross
    Federal debt between debt in the Trust Funds and debt held by the public
    would change, the total amount of gross debt would not change. The
    buildup of assets in the Trust Funds will correspond to a real increase
    in national wealth, and enhance the Government's ability to pay future
    benefits, only if it is saved by reducing the publicly held debt. This
    can be ensured if the Social Security surplus is protected by keeping
    the non-Social Security budget (approximately equal to the ``on-
    budget'') at least in balance. The consistent swing of the on-budget
    from deficit into surplus in this Administration has done just that.
      As is clear from Chart II-3, the shift from unified budget deficit to
    surplus was mainly due to the elimination of the on-budget deficit. But
    whichever framework is used, the Federal Government's fiscal position
    since President Clinton took office has improved dramatically.

      Government's Claim on the Economy Was Reduced while Prosperity Spurred
    Receipts: Federal spending reached the highest share of the economy
    since World War II in the 1980s; it was still 22.2 percent of GDP in
    1992. The defense buildup in the early 1980s, higher Federal interest
    payments

    [[Page 17]]

    because of increased debt and high interest rates, and large cost
    increases in Federal health programs overwhelmed all deficit-cutting
    efforts. This spending share turned down under President Clinton--even
    while the Administration increased Government investments in education,
    health care, the environment, and other priorities. In the last eight
    years, the ratio of Federal spending to GDP has steadily declined; in
    2000 it was down to 18.2 percent, the lowest since the 1960s. At the
    same time, a healthy economy plus a strong stock market raised Federal
    tax receipts. Though tax burdens on most families have declined, the
    share of Federal receipts in GDP rose from 18.5 percent in 1995 to 20.6
    percent in 2000--because of the rapid growth of incomes. Some of this
    increase may prove temporary; the Treasury Department estimates that
    receipts will decline to about 19.7 percent of GDP over the course of
    this decade--again, with no increase in tax rates (see Chart II-4).

      The United States Has Become a World Leader in Budgetary Performance:
    In the 1980s, world opinion often faulted the United States for its
    large budget deficits, which were believed to have raised worldwide
    interest rates and hampered economic growth. The Clinton-Gore
    Administration's fiscal policy changed this criticism to praise, as the
    United States became a leader among the G-7 countries. In 2001, the
    United States is projected to have the largest budget surplus as a share
    of its economy (see Chart II-5). This outstanding performance came not
    from higher tax rates, but from spending restraint. Though the United
    States supports the world's largest defense establishment, it still has
    the G-7's lowest public spending and taxes as percentages of GDP.

    Economic Performance

      Government does not make the economy grow; the private sector is the
    engine of economic growth. The American people have

    [[Page 18]]

    always been entrepreneurial and productive. However, the economy can
    grow faster and more consistently when budget policy, and monetary
    policy, are sound. Good budgetary policy is as important as monetary
    policy to such a successful outcome. And in fact, though the Federal
    Reserve has played a crucial role in this economic expansion, monetary
    policy was able to do its job better and more easily because of the
    sound fiscal policy of this Administration, as Fed members have
    acknowledged. Fiscal discipline, along with investment in our people and
    opening markets abroad--the other key elements of the Clinton economic
    strategy--has paid clear dividends in the economic performance of the
    1990s.

      Work Effort in the U.S. Economy Is at an All-Time High: Under the
    Clinton-Gore Administration, the share of the adult population that is
    employed has reached the highest point in U.S. history (see Chart II-6).
    The economic expansion, gaining strength as a result of greater
    confidence, lower interest rates, more investment, and accelerating
    productivity, created a veritable explosion of good job opportunities.
    Continuing investment in education at all levels improved the skills of
    new entrants into the labor force. Welfare reform and expansions of the
    Earned Income Tax Credit have increased labor force participation.

      Between January 1993 and December 2000, the unemployment rate fell
    from 7.3 percent to 4.0 percent--the lowest it has been since the end of
    the 1960s. The economy created more than 22 million jobs, of which 92
    percent were in the private sector, while Federal Government employment
    shrank. The net increase in jobs was larger under President Clinton than
    under the two previous Administrations combined. The healthy private
    labor market helped to make welfare reform a success by providing people
    leaving the welfare rolls with productive opportunities.

    [[Page 19]]

      Real wages have risen under this Administration; the increase has been
    especially noticeable since 1995. Over the last five years, real hourly
    earnings have increased at an average annual rate of 1.3 percent per
    year. Over the preceding 20 years, hourly earnings had been falling at
    an average annual rate of 0.4 percent per year.

      Administration Budget Policy Promoted National Saving: To get more
    capital, the economy needs more saving. For the economy as a whole, what
    matters is national saving--the sum of household saving, corporate
    retained earnings, and the Government surplus. Household saving is
    important, but it is only one component of national saving. A business
    that seeks to raise investment capital by floating a bond or selling a
    share of stock does not care, or even know, whether the funds come
    ultimately from households, other businesses, or government. National
    saving declined under the two preceding Administrations, but increased
    under President Clinton (see Chart II-7). This is a critical piece of
    evidence that the economic expansion of the 1990s is fundamentally
    different from that of the 1980s.

      Furthermore, as is shown in Chart II-7, the entirety of the
    improvement in national saving came from the reduction of the Federal
    budget deficit. (The Federal Government's budget improved by more than
    the total increase in national saving; State and local governments as a
    group run roughly balanced budgets in every year, and hence did not
    contribute significantly to the budget improvement.) The overwhelming
    contribution of budget policy toward eliminating the 1998 budget deficit
    came from the Clinton-Gore Administration's initial budget plan. The BBA
    of 1997 and the economic growth generated by the Administration's fiscal
    discipline finished the job.

    [[Page 20]]

      National saving went down in the 1980s, and up in the 1990s. National
    saving went up because Federal budget policy produced surpluses. And the
    Federal budget improvement began with the policy actions taken by the
    Administration in 1993.

      Lower Interest Rates Enhanced Investment: The point of the
    Administration's policy of increasing national saving was to reduce
    Government's drain on investable funds, to bring down interest rates
    while increasing the funds available for private investment. This is a
    matter of supply and demand; with a larger supply of investable funds
    because of increased Government saving, the price of the funds--the
    interest rate--would be expected to go down. With the enactment of the
    President's program, interest rates fell; and even though unemployment
    has steadily declined since, interest rates have remained at or below
    the levels of the preceding recession.
      With lower interest rates, businesses enjoyed a lower cost of capital
    for investment--a lower cost to take savings and convert it into capital
    for use in production. Given that national saving generally declined
    from 1980 to 1992, and increased from 1993 to the present, it might be
    expected that investment would be stronger under the current
    Administration than it was in the preceding 12 years; and again, that is
    what the record shows. The share of GDP devoted to business investment
    over the 1980s either declined slightly or was flat depending on the
    precise measure chosen. However, investment soared during the Clinton-
    Gore Administration (see Chart II-8).

      The ratio of real business equipment investment to real GDP reached
    12.4 percent in the third quarter of 2000. Since the beginning of 1993,
    inflation-adjusted investment in equipment and software has grown at an
    annual rate of 13.0 percent, more than 2\3/4\ times the rate of 1981-
    1992. The

    [[Page 21]]

    investment boom under President Clinton is the longest and strongest
    since World War II. The private sector has done the investing, but the
    Administration's policy of balanced budgets and fiscal responsibility
    clearly helped to bring interest rates down; and that helped to create
    the environment in which businesses could more confidently take business
    risks.

      The Benefits of Faster Productivity Growth: Economists believe that
    strong investment pays a double dividend. First, it increases the size
    of the productive base of the economy; with more factories and machines,
    output can expand. But second, to the extent that new factories and
    machines are more efficient than the ones they replace, then
    productivity (the amount of output that we get from each hour of work)
    will rise. Under President Clinton, productivity growth has broken from
    the trend line that had prevailed since the early 1970s (see Chart II-
    9).
      Enhanced productivity growth is important for many reasons; but
    perhaps most pertinent today, it makes an economic expansion more
    durable. Economic cycles usually end because inflation breaks out, which
    can occur when investment falls and productivity growth slows--as it did
    at the end of the 1970s, and the end of the 1980s. Continued strong
    investment has helped the current business expansion to continue for so
    long with low inflation. Productivity growth has increased, not
    declined, as this expansion has matured. Thanks to accelerated
    productivity growth due partly to increased capital intensity, the
    current expansion has lasted for almost 10 years; in February 2000, it
    became the longest expansion in U.S. history (the data go back to the
    mid-1800s), and each passing month sets a new record.

      Increasing productivity is also important because it is the only route
    to sustained real-wage and living-standard growth. In the 1970s, U.S.
    productivity growth slowed

    [[Page 22]]

    sharply. The average annual growth of output per hour in the nonfarm
    business sector fell from 2.8 percent (from 1949 through 1973) to 1.4
    percent (from 1974 through 1990). When productivity grows at 2.8 percent
    per year, living standards double every quarter-century; but when
    productivity grows at only 1.4 percent per year, incomes grow by less
    than half. Over a generation, many workers can find themselves falling
    behind their parents, as well as their own expectations.
      From the 1970s through the early 1990s, productivity growth stalled at
    the new slower rate. Since the mid-1990s, however, nonfarm business
    output per hour has grown at an average of 3.0 percent per year--
    slightly higher than the rate before the 1970s' slowdown (the break in
    the trend is shown in Chart II-9). Some of the speedup could be due to
    temporary factors; but the persistence of the higher growth rate for
    five years suggests that somewhat faster growth may be sustained. This
    is welcome news, not only for businesses seeking to hold down costs, but
    also for typical workers and their families, who once again see real
    improvements in their earnings.

      The Misery Index Is Near a 30-Year Low: The success of budget and
    monetary policies shows also in the low unemployment and inflation under
    this Administration. The Misery Index--the sum of the annual
    unemployment rate and the core Consumer Price Index (CPI) inflation
    rate--was lower than at any time since the 1960s (see Chart II-10).

      In 2000, the unemployment rate has averaged 4.0 percent--the lowest
    yearly average since 1969--while inflation has averaged just 2.7 percent
    (as measured by the core CPI, excluding volatile food and energy
    prices). The inflation rate crept up this year after its 34-year low in
    1999, but remains near its average since 1995. This is the fifth year in
    a row of core inflation under three

    [[Page 23]]

     percent--the best five-year record since the 1960s.
      The turnaround in economic performance under President Clinton--faster
    economic growth, falling unemployment, and lower inflation--happened in
    the private sector; but it was aided by the Administration's budget
    policy and the Federal Reserve's monetary policy. The past eight years
    demonstrate that fiscal discipline and a matching monetary policy can
    generate more work, saving, and investment than an easy budget policy
    that ignores deficits and debt.

    The Economic Outlook

      The Clinton-Gore Administration has developed a final economic
    forecast, continuing its conservative, prudent approach (See Table II-
    1). No economic forecaster is accurate all the time, but the
    Administration believes that it makes more sense to plan for middle-of-
    the-road conditions, so that any budget errors are likely to be in the
    ``right'' direction, rather than to make long-term commitments for the
    best-case forecast, only to see spiraling uncontrolled deficits and
    debt. Previous Administrations more often overestimated economic
    performance; such mistakes are dangerous, because they can encourage
    policymakers to avoid hard and essential choices. One of the
    Administration's most important early decisions was to adopt a realistic
    economic forecast, and this philosophy has served the Nation well.

    [[Page 24]]

    Table II-1.  Economic Assumptions \1\
                                                                              (Calendar years; dollar amounts in billions)
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                          Projections
                                                                                  Actual -----------------------------------------------------------------------------------------------------------
                                                                                   1999     2000     2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

    Gross Domestic Product (GDP):-------------------------------------------------------------------------------------------------------------------------------------------------------------------
      Levels, dollar amounts in billions:
        Current dollars........................................................    9,299    9,991   10,536   11,099   11,695   12,324   12,986   13,676   14,388   15,122   15,888   16,692   17,536
        Real, chained (1996) dollars...........................................    8,876    9,337    9,645    9,954   10,272   10,601   10,941   11,284   11,627   11,968   12,315   12,672   13,039
        Chained price index (1996 = 100), annual average.......................    104.8    107.0    109.2    111.5    113.8    116.2    118.7    121.2    123.7    126.3    129.0    131.7    134.5
      Percent change, fourth quarter over fourth quarter:
        Current dollars........................................................      6.5      6.7      5.3      5.4      5.4      5.4      5.4      5.3      5.2      5.1      5.1      5.1      5.1
        Real, chained (1996) dollars...........................................      5.0      4.1      3.2      3.2      3.2      3.2      3.2      3.1      3.0      2.9      2.9      2.9      2.9
        Chained price index (1996 = 100).......................................      1.6      2.4      2.0      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1
      Percent change, year over year:
        Current dollars........................................................      5.8      7.4      5.5      5.3      5.4      5.4      5.4      5.3      5.2      5.1      5.1      5.1      5.1
        Real, chained (1996) dollars...........................................      4.2      5.2      3.3      3.2      3.2      3.2      3.2      3.1      3.0      2.9      2.9      2.9      2.9
        Chained price index (1996 = 100).......................................      1.5      2.2      2.0      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1

    Incomes, billions of current dollars:
        Corporate profits before tax...........................................      823      934      922      934      961      990    1,035    1,080    1,127    1,162    1,196    1,226    1,251
        Wages and salaries.....................................................    4,470    4,767    5,031    5,310    5,608    5,917    6,233    6,566    6,904    7,264    7,637    8,028    8,437
        Other taxable income \2\...............................................    2,141    2,286    2,353    2,422    2,488    2,561    2,649    2,745    2,843    2,943    3,048    3,152    3,263

    Consumer Price Index (all urban): \3\
        Level (1982-84 = 100), annual average..................................    166.7    172.3    176.8    181.4    186.2    191.2    196.4    201.7    207.2    212.7    218.5    224.4    230.4
        Percent change, fourth quarter over fourth quarter.....................      2.6      3.4      2.5      2.6      2.7      2.7      2.7      2.7      2.7      2.7      2.7      2.7      2.7
        Percent change, year over year.........................................      2.2      3.4      2.7      2.6      2.7      2.7      2.7      2.7      2.7      2.7      2.7      2.7      2.7

    Unemployment rate, civilian, percent:
        Fourth quarter level...................................................      4.1      4.0      4.3      4.6      4.7      4.8      4.9      5.0      5.1      5.1      5.1      5.1      5.1
        Annual average.........................................................      4.2      4.0      4.1      4.4      4.6      4.7      4.8      4.9      5.0      5.1      5.1      5.1      5.1

    Federal pay increases, percent:
        Military and civilian \4\..............................................      3.6      4.8      3.7      3.9      3.9      3.9      3.9      3.9      3.9      3.9      3.9      3.9      3.9

    Interest rates, percent:
        91-day Treasury bills \5\..............................................      4.7      5.9      6.0      5.7      5.4      5.3      5.3      5.3      5.3      5.3      5.3      5.3      5.3
        10-year Treasury notes.................................................      5.6      6.1      5.8      5.8      5.8      5.8      5.8      5.8      5.8      5.8      5.8      5.8      5.8
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
    \1\ Based on information as of mid-November 2000.
    \2\ Rent, interest, dividend and proprietor's components of personal income.
    \3\ Seasonally adjusted CPI for all urban consumers. Two versions of the CPI are now published. The index shown here is that currently used, as required by law, in calculating automatic
      adjustments to individual income tax brackets.
    \4\ Beginning with 2002, projected increases in the Employment Cost Index for private industry wages and salaries.
    \5\ Average rate (bank discount basis) on new issues within period.

    [[Page 25]]

    The Near-Term Outlook

      Real GDP Growth: Over the coming 10 years, the Blue Chip panel of 50
    forecasters predicts a trend of real GDP growth averaging around 3.3
    percent for most of the decade. The Administration's forecast for the
    next five years averages 3.2 percent. After 2005, the Administration
    projects growth slowing gradually to 2.9 percent per year in 2009-2011.
    Later this decade, the large baby-boom generation--born in the 20 years
    following World War II--will begin to retire. When that happens, labor
    force growth is likely to slow, pulling down real GDP growth. The
    initial effects of this demographic transition are reflected in the
    Administration's projections of real GDP for 2006-2011. It is not clear
    whether the private forecasters have begun to take account of this
    predictable shift in the labor force.
      It is uncertain how much of the actual acceleration in productivity
    growth since 1995 will be sustained; but since last year's forecast,
    favorable evidence has mounted, and most economists are now more
    sanguine about prospects for productivity growth. Compared with the 2001
    Budget assumptions, the Administration has increased projected potential
    GDP growth, and now projects that labor productivity in the nonfarm
    business sector can increase at an average rate of 2.2 percent per year
    through 2011.

      Unemployment and Inflation: The unemployment rate in December was 4.0
    percent, near the lowest point in three decades. It is projected to rise
    somewhat over the next few years, and to stabilize at an average rate of
    5.1 percent--still well below the 6.7 percent average rate from 1970
    through 1992.
      Inflation was boosted this year by a spike in oil prices; but oil
    futures market prices imply relief in 2001, and so inflation is likely
    to decline. The Administration projects CPI inflation of 2.5 percent in
    2001 (on a fourth quarter to fourth quarter basis), following a 3.4
    percent rate during 2000. CPI inflation is expected to average 2.7
    percent per year for 2002 through 2011--close to the average of 2.5 over
    the past five years. Inflation in the GDP chain-weighted price index is
    projected to average 2.1 percent through 2011. These projections
    maintain the gap that has emerged in recent years between these two
    measures of inflation.
      For several years, real GDP has grown faster than mainstream
    forecasters believed would be sustainable without higher inflation. This
    year's moderate upward revision to the estimate of potential GDP growth
    is consistent with this performance; strong investment in new
    technologies is paying off in higher productivity. However, some of the
    rapid GDP growth of the last eight years came because labor force
    participation was increasing and unemployment was falling. Looking
    ahead, the unemployment rate is likely to rise slightly and labor growth
    is projected to slow, which the Administration believes will moderate
    the pace of GDP growth.

      Interest Rates: Interest rates on Treasury debt fell to extremely low
    levels--short maturities under five percent--during the world financial
    crisis of 1997-1998. Since then, short-term rates--following several
    interest rate hikes by the Federal Reserve during 1999 and 2000--have
    risen to their highest level since 1991; the 91-Day Treasury Bill
    discount rate was 5.7 percent in late December. The yield on 10-year
    Treasury notes also rose in 1999, but it retreated in 2000; in late
    December, it was about \1/2\ percentage point below the short-term rate.
    The Administration projects that the 10-year rate will average near 5.8
    percent--its level of mid-November--throughout the forecast period.
    Meanwhile, the short-term rate is projected to decline gradually to
    around 5.3 percent, which would restore the usual upward-sloping yield
    curve. The outlook is complicated by the ongoing reduction in Federal
    debt, which gradually removes Government bills, notes, and bonds from
    the market.
      Trend Projections: Except in the near term, the projections shown in
    Table II-1 are not a precise year-to-year forecast; instead, they
    reflect the average behavior expected for the economy over the medium
    term. In some years, growth could be faster than assumed; in other
    years, it could be slower. Similarly, inflation, unemployment, and
    interest rates could fluctuate around the projected values. If the
    assumptions hold on average, however, they should provide a prudent
    basis for budgeting. If fiscal and monetary policies remain sound, the
    economy could continue to

    [[Page 26]]

    outperform these relatively conservative projections, as it has for the
    past several years.

    The Budget Outlook

      The Near-Term Outlook: The Administration projects continuing budget
    surpluses in 2001 and subsequent years. On current-services assumptions,
    the unified surplus is projected at $256 billion in 2001 and $277
    billion in 2002. The on-budget surplus, $86 billion in 2000, is
    projected to be $98 billion in 2001. By 2011, it could reach $479
    billion.

      These projections are imprecise, and if experience is any guide, they
    could err by large margins. The future is uncertain, and the more
    distant the projection, the greater the uncertainty. Over the history of
    five-year budget projections (first required by the Congressional Budget
    Act of 1974, and thus starting with the 1976 Budget), every
    Administration has made substantial errors. Chart II-11 shows that the
    average forecast error for the deficit/surplus (regardless of sign,
    expressed as a percentage of GDP) of the fiscal year already in progress
    was 0.6 percent of GDP (in today's terms, over $60 billion--not a
    trivial sum for a year already one-fourth over). The average error for
    the coming year was twice as large--1.2 percent (or more than $120
    billion today). Errors grew even larger as the projection was more
    distant, averaging 4.0 percent of GDP (more than $400 billion today) for
    the five-year ahead (the most distant) projections. (The Clinton-Gore
    Administration's errors were only slightly smaller than those of other
    Administrations, though unlike all the others, we have run smaller
    deficits and larger surpluses than we projected.) Such enormous
    uncertainty about budgets just a few years in the future should
    influence policymakers' decisions about expensive, long-term commitments
    on the basis of mere projections--especially now, when the public debt,
    though declining, is still about the same percentage of GDP as in 1985;
    and

    [[Page 27]]

    when the baby-boom generation is just seven years away from beginning to
    collect Social Security benefits.

      The Long-Term Outlook: Though long-run budget projections are
    inherently uncertain, they can warn of potential problems, which may be
    more easily solved if addressed sooner. In the 1990s, policymakers
    increasingly focused on long-range projections, some looking as far as
    75 years ahead--especially for the budget effects of population aging
    and reforms to Social Security or Medicare.
      Prior to the 1993 Clinton program, the Federal deficit was projected
    to spiral out of control in this decade. The outlook improved after
    OBRA, although deficits continued for a time. Following the passage of
    the BBA in 1997, a unified budget surplus was projected beginning in
    2002, and for about 20 years; even so, the deficit was expected to
    return in the long run.
      Since 1997, the economy and the budget have performed much better than
    projected when the BBA was passed. Projections of publicly held Federal
    debt have steadily declined. Lower interest payments have reinforced the
    improvement of the budget, and have significantly extended the long-run
    surplus projections. Still, the long-term current services baseline is a
    mechanical extrapolation of the budget implications of current law, and
    thus is not intended to reflect likely policy actions. Moreover, the
    range of uncertainty around such projections is very large. Under
    reasonable alternative assumptions, the budget could return to deficit
    within a few years following the retirement of the baby-boomers. The
    underlying demographic pressures are formidable, and if the demographic
    or economic outcomes prove to be less favorable than assumed here, the
    surplus would be threatened. (See Budget of the United States
    Government, Fiscal Year 2001: Analytical Perspectives, chapter 2; and
    Economic Report of the President, January 2001, chapter 2.)
      The favorable long-term budget results in these projections can be
    realized only with prudent policy--choosing continuing reductions in
    outstanding debt, rather than expensive tax cuts or spending increases--
    while sustaining private saving, investment, and productivity growth.