What is the cyclical deficit and why should we care

Free Slides fromEd Dolan’s Econ Bloghttp://dolanecon.blogspot.com/Budget Basics: What is the Cyclically Adjusted Deficit and Why Should We Care?Post prepared June 10, 2010Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers.

Post P100610 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/The Deficit DebateA furious debate is underway in Congress, in the press, and in the blogosphere over the U.S. budget deficit, which hit a post-World War II record in 2009Is the deficit a dire threat that we should attack immediately?Should we instead focus on creating jobs and stimulating the economy, and let the deficit take care of itself?

Post P100610 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/How Much of the Deficit is Due to the Recession?What to do about the deficit depends in part on how much of it is a result of the recessionIf most of it is due to the recession, we can safely worry about jobs now, and let the deficit take care of itselfIf the deficit is due to runaway federal spending or reckless tax cuts, it we had better do something about it now?

Post P100610 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/The Cyclically Adjusted DeficitThe non-partisan Congressional Budget Office provides an estimate of how much of the deficit is caused by the recessionThe actual deficit shows the full gap at any time between revenue and outlaysThe cyclically adjusted deficit shows how large the deficit would be if the economy were operating at full employment

Vocabulary NotesThe cyclically adjusted budget deficit can also have two other names:The structural budget deficitThe deficit without automatic stabilizersInstead of saying when the economy is operating at “full employment,” economists often prefer one of these two terms:Potential real outputNatural level of real outputPosting P100130 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Post P100610 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/Automatic StabilizersThe actual deficit varies over the business cycle in part because of automatic stabilizers—elements of the budget that move it toward deficit in a recession and toward surplus during expansionIncreases in tax revenue when the economy expands are one kind of automatic stabilizerIncreases in spending on unemployment benefits as the economy contracts are another kind of automatic stabilizerIn 2000, automatic stabilizers created an actual surplus greater than the adjusted surplus In 2009, automatic stabilizers made the actual deficit 1.9% greater than the adjusted deficit

Post P100610 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/Interpreting the Adjusted Deficit to Read Policy ChangesThe cyclically adjusted deficit can be interpreted as showing changes in policyIn the 1990s, the Clinton administration undertook measures to reduce the deficit, and eventually produce a surplusIn the early 2000s, Bush administration tax cuts and wars moved the budget toward deficitIn 2009, Obama administration stimulus measures greatly increased the deficit

Post P100610 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/How Accurate are the Numbers? Measuring the Output GapTo estimate the adjusted deficit, economists must first estimate the output gapThe gap is positive when GDP is above potential and negative when GDP is below potentialThis chart shows that different methods of measuring the output gap can differ by as much as 2% of GDPConclusion: The adjusted deficit can be measured approximately, but not precisely

Post P100610 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/Forecasting Future Deficits: Growth AssumptionsNow zoom in on the CBO deficit projections for 2010-2014Notice that the cyclically adjusted deficit and actual deficit come together in 2014That happens because the CBO assumes the economy will be at or close to full employment by thenIf the recovery is slower, the actual deficit will be larger than forecast, and smaller if the recovery is faster

Post P100610 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/Forecasting Future Deficits: Policy AssumptionsNotice also that the cyclically adjusted deficit is assumed to shrink to less than 3% of GDPThat happens largely because the CBO is required by law to base its forecasts on legislation that is now on the books, not hopes or promises of future policy changes . . .

Post P100610 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/Forecasting Future Deficits: Policy Assumptions (continued). . . In particular, these CBO projections assume that Congress will let the Bush tax cuts fully expire at the end of 2010Everyone one knows that is not likely to happenThe Republicans want to extend all the Bush tax cutsThe Democrats want to extend all tax cuts for families earning under $250,000 a yearIn addition, the forecasts assume no adjustment of the alternative minimum tax—also unlikely, since Congress has repeatedly adjusted it in the past

Post P100610 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/The Bottom Line: Not so Rosy After AllThe Bottom Line: Although CBO projections show that the deficit will shrink from 9.3% of GDP to a sustainable 2.6% by 2014, only 1.7% of the decrease is due to the operation of automatic stabilizersThe rest is wishful thinking based on the assumption that Congress will do something it is unlikely actually to do, namely, permit large increases in tax rates

What is the cyclical deficit and why should we care

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What is the cyclical deficit and why should we care