Thursday, June 10, 2010

Budget Basics (1): What is the Cyclically Adjusted Deficit and Why Should We Care?

A furious debate over the federal budget deficit is underway in Congress, in the press, and in the blogosphere. Is the deficit a dire threat that we need to attack with immediate austerity measures? Should we instead focus on more stimulus to create jobs, in the expectation that the deficit will take care of itself as the economy expands?

The answer to these questions depends part on how much of the deficit is caused by the recession. If most of the deficit is cyclical, we can hope that more stimulus spending now will actually shrink the deficit. If it is mostly caused by runaway spending or reckless tax cuts, it would make more sense to do something about the deficit right away.

The CBO has addressed this issue with new estimates of the cyclically adjusted budget deficit--deficit as it would look when the effects of the business cycle are stripped away. These estimates show that automatic stabilizers contributed about 1.9 percentage points of the record 9.3 percent federal deficit in 2009. The CBO numbers also show the deficit shrinking to a relatively comfortable 2.6% of GDP by 2014, when it expects the economy to be at or close to potential real output.

At first glance, these numbers are reassuring. They lend support to the argument for more stimulus and a faster return to potential real GDP, with the deficit taking care of itself. But, unfortunately, we cannot simply take the CBO projections at face value.

First of all, they are only estimates. To estimate the adjusted budget deficit, the CBO must first estimate the output gap. An interesting recent study from the Federal Reserve shows that different methods of measuring the output gap can vary by as much as 2% of GDP. So, not only can we not be sure how fast the economy will approach potential real output, we don't really know exactly where the potential is.

An even more serious problem lies in the well-known fact that the CBO, by law, makes its projections on an assumption that existing legislation will remain unchanged. Its recent rosy projections of the deficit are largely due to the assumption that the Bush tax cuts will be allowed to fully expire (even though neither Democrats nor Republicans want that to happen), and that there will be no further adjustments of the alternative minimum tax (even though Congress has repeatedly adjusted it in the past). If we strip out these assumptions, the chances that the deficit will shrink to a sustainable level by 2014 look much slimmer.

Follow this link to download a free set of slides for use in your economics course. The slides discuss the cyclically adjusted budget deficit, automatic stabilizers, the output gap, and related concepts and include relevant charts and definitions of terms. Additional posts in this Budget Basics series are planned for the near future.

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