Author: G.I. | WASHINGTON

NOTHING better explains the fiscal setback Barack Obama’s domestic agenda has suffered in the last year than this sentence from the budget:

Since the [previous budget] was released in February of 2009, unfavorable economic conditions and technical re-estimates have worsened the deficit outlook by $2 trillion through 2019—the equivalent of 1 percent of GDP per year—with a deterioration of about $200 billion in 2015 alone.

Got that? $2 trillion gone, with nothing to show for it: no new tax cuts, no new domestic programmes, not even new bail-outs: just gone because the economy is delivering up less tax revenue than Mr Obama anticipated a month after taking office.

A smaller GDP is only part of the story; the other part is those notorious “technical re-estimates”. For non-geeks, that usually means a dollar of GDP is delivering less revenue than it used to, perhaps because higher-taxed income like bonuses and stock options has fallen more sharply than other income. That lost revenue goes straight to the deficit, which is then compounded with higher interest in later years.

Even after Mr Obama raises the top two tax brackets, lets his beloved  “making work pay” tax credit expire after 2011 (he had wanted it to be permanent), gives up any expected revenue from cap-and-trade and pencils in hundreds of billions of dollars of tax increases on the rich and multinationals, revenue for the next decade still averages just 18.3% of GDP, exactly what it averaged from 1980 to 2007. A year ago Mr Obama thought the deficit would fall to 3% of GDP by 2015. Now, he sees it falling to just 3.9% (and that’s assuming health care savings, a discretionary spending freeze and a variety of other measures).

BARACK OBAMA has picked a curious target for his deficit commission: balance the primary budget by mid-decade. The primary budget excludes interest. Since interest payments are about 3% of GDP by 2015, that means getting the total deficit down to 3% of GDP, versus 3.9% as currently projected.

Why is this curious? Because a better goal would be to stabilise debt as a share of GDP. Peter Orszag, the budget director, notes that these two amount to the same thing; balancing the primary budget would stabilise the debt as a share of GDP in the mid-60% range, net of financial assets. (Without action, the debt instead rises to 69% by 2020, 77% before netting out financial assets.)

But it’s not by construction that these two goals produce the same result; it’s only true as long as interest rates are equal to nominal GDP growth. If rates are higher than nominal growth, the debt/GDP ratio keeps climbing unless there are ever larger spending cuts or tax increases. The administration sees interest rates at 4% to 5%, just low enough to equal nominal GDP between now and 2020. That means that balancing the primary budget does stabilise the debt.

This arithmetic falls apart if interest rates climb notably, as they are wont to do when a country encounters a fiscal crisis. Greece’s bond yields are now almost 7%, nominal growth has averaged 3.8%, Greece may be unable to roll over maturing debt, and the odds of default are climbing. Not saying that will happen to America, but Mr Orszag and the deficit commission should keep the possibility at the back of their minds.

In the tussle over whether deflation or inflation is the bigger threat I’ve been firmly in the deflation camp. In the last few weeks, though, I’ve tiptoed closer to neutral. Core inflation hasn’t dropped as much as I’d expected to date, and the drop that has occurred seems entirely due to owners’ equivalent rent. Goods prices inflation has been surprisingly sturdy.

Yesterday’s report by the Congressional Budget Office also prompted me to reexamine my assumptions. The CBO has raised its CPI inflation rate forecast for 2010 to 2.4% from 1.7%, while leaving the 2011 forecast at a still very low 1.3%. It marked down even more its forecast of inflation as measured by the GDP price index

The CBO says:

The projection of inflation (measured by growth in the PCE price index) was revised upward by between 0.3 percent and 0.4 percent over the next three years, in part because import prices are expected to increase more rapidly than CBO last projected, and also because excess capacity seems to be having a somewhat more modest impact on inflation than was previously thought.

(As an aside, this revision explains a lot of the reduction in the CBO’s 10-year deficit estimate from its August projection, to $6.7 trillion from $7.1 trillion. Higher inflation raises nominal GDP and thus revenue. The CBO also marked down its average interest rate forecast for that period, largely because the private sector did, too. This reduced interest costs.)

Some of the inflation revision is because of the lower dollar, which is putting upward pressure on prices of tradable goods. The CBO also seems to think higher unemployment is exerting less disinflationary influence than traditional estimates of this relationship, called the Phillips Curve, assume. Inflation hawks at the Fed and elsewhere have made this argument for some time; I find it interesting the CBO is giving it some credence since, like me, the CBO puts a lot of stock in the Phillips curve.

I haven’t switched my deflation alarms off altogether. Goldman Sachs has argued that most of the sturdiness in inflation to date reflects just four categories: gasoline, cars, tobacco, and medical care, and “only the last of these seems likely to repeat its contribution from 2009.” Moreover, the most direct evidence of the output gap’s impact is wage growth, which continues to slow.

But the odds of outright deflation, as opposed to very low inflation, seem to have diminished a lot.

IN ITS updated global forecast released this morning, the IMF warns against “premature and incoherent exit” from government support for the economy. “Incoherent” nicely describes the policy debate in Washington. Partisans have aimed their poison at the Federal Reserve and at the government’s fiscal policy choices but what, exactly, do they want? The logical implications of their complaints are contradictory at best and dangerous at worst.

Start with the Fed. On the right, they’re angry about quantitative easing which they say is monetising deficits. On the left, they’re angry about lax regulation of banks. Both are furious at bail-outs of banks and AIG, and both think the Fed created a bubble with its low interest rates. So the Fed, presumably, should shrink its balance sheet, end its asset purchases and liquidity programmes, order banks to raise underwriting standards and raise rates to nip the next bubble in the bud. And this is going to bring unemployment down?

The Fed won’t do any of these things (not this week, anyway). But the intensity of attacks could shape its behaviour, and not for the better. The confirmation circus is surely the last nail in the coffin of any additional quantitative easing (already being wound down in part because of political blowback). As Vincent Reinhart tells the Wall Street Journal, Harry Reid’s endorsement of Mr Bernanke’s confirmation is a “death trap” because it implies he extracted favours from the Fed in return. Yes, such things are tossed around all the time in confirmation hearings, but the circumstances of this one are especially cringe-worthy. Buy more mortgage-backed securities now, and everyone will see payback to Mr Reid. Perversely, to avoid perceptions of political pliability, the Fed may err on the side of less stimulative monetary policy. Meanwhile, to atone for past sins bank regulators are breathing down lenders’ necks and even Mr Bernanke admits “uncertainty attending … regulatory capital standards” is suppressing the supply of credit.

For now, the stand-off on regulatory reform will spare the Fed formal infringement of its independence. But even assuming Ben Bernanke is confirmed, the mud fight has left the institution vulnerable. The administration has two vacancies to fill on the Fed’s seven-member board of governors—more if some of the current governors retire. Could Donald Kohn, whose term as vice-chairman ends in June, be reconfirmed in this atmosphere? This week’s events may tempt the administration to elevate political palatability over technical ability in whom it chooses to nominate. A weakened board means a louder voice for the Fed’s hawkish reserve bank presidents.

On fiscal policy, voters seem equally upset about deficits and high unemployment as if the first has caused the second when the reverse is true. Republicans have certainly fanned this perception by insisting the stimulus did nothing (helped by the administration’s overly optimistic 8% unemployment forecast). Sometimes, though, President Obama feeds the confusion. Last fall he warned that adding to the national debt could lead to a double-dip recession (turning Keynesian economics on its head, ISI Group notes). This week, even as Congress prepares additional stimulus, Mr Obama has begun ringing the fiscal austerity gong, backing a deficit commission (albeit too late to make a difference) and offering a discretionary spending freeze.

Done right, stimulus now and deficit reduction later is good policy. Yet such delicate sequencing is tough enough in rational times, never mind this post-Massachusetts world. Can a Congress in thrall to the extremes of either party really guide the economy safely past the “cliff” when both the stimulus and the Bush tax cuts expire at the end of this fall, and do so without freaking out bond markets on the look-out for an English-speaking Greece? The risk of a policy error, always high, may be rising.