Structural deficits – the great con job!

There has been a lot of talk lately about the need for the Government to plot a course over the coming years back into fiscal surplus. Our perceptions of fiscal responsibility are being conditioned by the relentless media campaign that this is the best thing for the Government to do. We are being told that cyclical deficits are unavoidable at this time but the “structure of the budget” should point us back to surplus as soon as possible. This campaign is being supported by official looking documents that are produced by Treasury (notably the Budget papers) which have all sorts of technical terms in them that only the cognoscenti understand. The term structural deficit is being touted around in these documents and appearing in the opinion columns. But the way this concept is being represented is very misleading and is deliberately being used to obfuscate the lack of intention by this Government to seriously pursue full employment. Well lucky for me I am part of the cognoscenti and cannot be so easily fooled. Here is the truth.

The federal budget balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. It is a simple matter of accounting with no theory involved. However, the budget balance is used by all and sundry to indicate the fiscal stance of the government.

So if the budget is in surplus we conclude that the fiscal impact of government is contractionary (withdrawing net spending) and if the budget is in deficit we say the fiscal impact expansionary (adding net spending).

However, the complication is that we cannot then conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty is that there are automatic stabilisers operating. To see this, the most simple model of the budget balance we might think of can be written as:

Budget Balance = Revenue – Spending.

Budget Balance = (Tax Revenue + Other Revenue) – (Welfare Payments + Other Spending)

We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the Budget Balance are the so-called automatic stabilisers

In other words, without any discretionary policy changes, the Budget Balance will vary over the course of the business cycle. When the economy is weak – tax revenue falls and welfare payments rise and so the Budget Balance moves towards deficit (or an increasing deficit). When the economy is stronger – tax revenue rises and welfare payments fall and the Budget Balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the budget in a recession and contracting it in a boom.

So just because the budget goes into deficit doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.

To overcome this uncertainty, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. The change in nomenclature is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation. I will come back to this later.

The Full Employment Budget Balance was a hypothetical construct of the budget balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the budget position (and the underlying budget parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.

So a full employment budget would be balanced if total outlays and total revenue were equal when the economy was operating at total capacity. If the budget was in surplus at full capacity, then we would conclude that the discretionary structure of the budget was contractionary and vice versa if the budget was in deficit at full capacity.

The calculation of the structural deficit spawned a bit of an industry in the past with lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.

Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s. All of them had issues but like all empirical work – it was a dirty science – relying on assumptions and simplifications. But that is the nature of the applied economist’s life.

Things changed in the 1970s and beyond. At the time that governments abandoned their commitment to full employment (as unemployment rise), the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) entered the debate – see the blog – The dreaded NAIRU is still about.

The NAIRU became a central plank in the front-line attack on the use of discretionary fiscal policy by governments. It was argued, erroneously, that full employment did not mean the state where there were enough jobs to satisfy the preferences of the available workforce. Instead full employment occurred when the unemployment rate was at the level where inflation was stable.

NAIRU theorists then invented a number of spurious reasons (all empirically unsound) to justify steadily ratcheting the estimate of this (unobservable) inflation-stable unemployment rate upwards. So in the late 1980s, economists were claiming it was around 8 per cent. Now they claim it is around 5 per cent. The NAIRU has been severely discredited as an operational concept but it still exerts a very powerful influence on the policy debate. In Australia, it dominates the Treasury and the Reserve Bank modelling.

Further, governments became captive to the idea that if they tried to get the unemployment rate below the NAIRU using expansionary policy then they would just cause inflation. I won’t go into all the errors that occurred in this reasoning. My latest book – Full Employment Abandoned with Joan Muysken is all about this period.

Now I mentioned the NAIRU because it has been widely used to define full capacity utilisation. If the economy is running an unemployment equal to the estimated NAIRU then these clowns concluded that the economy is at full capacity. Of-course, they kept changing their estimates of the NAIRU which were in turn accompanied by huge standard errors. These error bands in the estimates meant their calculated NAIRUs might vary between 3 and 13 per cent in some studies which made the concept useless for policy purposes.

But they still persist in using it because it carries the ideological weight – the neo-liberal attack on government intervention.

So they changed the name from Full Employment Budget Balance to Structural Balance to avoid the connotations of the past that full capacity arose when there were enough jobs for all those who wanted to work at the current wage levels. Now you will only read about structural balances.

And to make matters worse, they now estimate the structural balance by basing it on the NAIRU or some derivation of it – which is, in turn, estimated using very spurious models. This allows them to compute the tax and spending that would occur at this so-called full employment point. But it severely underestimates the tax revenue and overestimates the spending and thus concludes the structural balance is more in deficit (less in surplus) than it actually is.

They thus systematically understate the degree of discretionary contraction coming from fiscal policy.

This pretty much sums it up but more at Bill Mitchell’s.

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One response to “Structural deficits – the great con job!

  1. Pingback: is 2012 real?

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