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 my blogs – The dreaded NAIRU is still about and Redefing full employment … again!.

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. People will seek more chances to save. 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.

So they are trying to tell us that the business cycle moves around a fixed point – currently around 5 per cent unemployment – and above that the economy is operating with spare capacity and below it the economy is operating over full capacity.

As a consequence you get the following graph which appeared in Budget Statement 4: Assessing the Sustainability of the Budget:

This is an example of the decomposition of the federal budget balance into cyclical and structural factors. According to the Treasury:

Based on these estimates, the structural budget balance deteriorated from 2002-03, moving into structural deficit in 2006-07. This shows that the actual underlying cash balances in previous years were primarily the result of the strength in Australia’s terms of trade, which increased by almost 40 per cent over this period. While the temporary fiscal stimulus measures result in a widening of the structural deficit, the deficit narrows over the medium term reflecting savings measures and the Government’s commitment to reduce spending as the economy recovers.

What they are saying is that the surpluses in the recent years were not structural but were driven by cyclical factors – the booming commodities prices. They are also saying that the underlying or structural budget has gone into deficit due to the discretionary changes of the Federal Government (the stimulus packages) and that by 2015-2116, the structural balance will be back in surplus. The falling deficit is projected on the basis of discretionary decisions made by the government to reduce outlays over this period.

But of-course, given the earlier discussion, this is all dependent on what you call “full capacity”. I define full employment as an economy that delivers as many jobs as their are people wanting them and hours of work consistent with the desired hours of the workers. In other words, an economy that has an unemployment rate around 2 per cent and zero underemployment. That is a far cry from the “full capacity” dodges used by the OECD, the IMF and the Australian Treasury. Their conceptions of full capacity are ideologically-loaded by the NAIRU concept and are frankly … a total joke.

So I thought I might just quickly estimate the structural balance based on an unemployment rate of 2 per cent. For simplicity I am ignoring the fact that increasingly those in employment are experiencing underemployment. Remember to be counted as employed you only have to work 1 hour per week. More workers are reporting they are being forced into part-time hours but want to work longer. So by ignoring this problem my estimates are significantly underestimating the full capacity position of the economy and will underestimate any structural surpluses that I calculate. Bear that in mind.

The steps in the calculation were:

• Compute Potential GDP by calculating the level of employment for each quarter if the unemployment rate = 2 per cent and ignoring labour participation changes (participation would be higher if the employment levels were higher). Then I computed actual labour productivity in persons and used the potential employment series to estimate what GDP would in each quarter at full capacity.
• I then estimated some regressions to compute the cyclical revenue and spending elasticities. In particular, I estimated an equation for tax revenue (a part of total revenue) and an equation for welfare and social spending (a part of total spending). They were regressed on the GDP gap in percentage terms in log form to estimate how sensitive these components of the budget were to deviations in the business cycle. I could have done this in a more detailed manner by estimating elasticities for different tax components etc but when I compared by outcomes with the estimates used by the IMF and the OECD they were fairly close. In fact, I could have saved myself time and just used their elasticity estimates without changing the results.
• I then used the cyclical elasticities to estimate the structural revenue and outlays (so T(s) = T*(%Output Gap)^elasticity and the same for outlays). I added the cyclically sensitive components of outlays and revenue back into total outlays and revenue and derived the Operating (cash) position. I simplified by not taking into account the recent shift to accruals for the operating result. Again this will not alter the result much.
• I also smoothed out the GST effect in the official data – again this doesn’t make any difference to the overall results – it just eliminates a big spike in the data around July 2001. Further, some missing observations in the official data were just interpolated (2 quarters) – with no major impact on the conclusions.
• This is deliberately simple but the conclusions are not dependent on the simplified approach I took.

The following graph shows you the actual operating results (Total Revenue minus Total Spending) since 1974 and the structural operating balance (computed as above). The difference between the structural and the actual reflects the fact that over this period the economy has never operated at 2 per cent unemployment. The difference between this estimate of the structural balance and the Treasury’s estimate lies in the fact that they are assessing full capacity at a much higher unemployment rate – which is not the full employment level of the economy.

So the Treasury estimates of the structural balance build in the assumption that the Government will not achieve anything remotely like full employment over the period shown in the graph. By the time the graph is crossing the zero line again (in several years) the economy will be at the NAIRU or around 5 per cent unemployment. That is not admitted in any of these public documents nor by the journalists.

The Australian econmics editor, Michael Stutchbury used this same Treasury graph above earlier this week in his Swan’s surplus of silence article and did not tell his readers about this underlying bias in the calculations. He should have because it would have influenced the way his readers interpreted and judged his article. They would have thought it a poor piece of journalism if they knew the basis of the discussion.

If you examine my graph you can see the actual balance (blue line) is well below the estimated structural balance (red line). The Federal Government has been running contractionary budget positions (structurally) since 1976. So the deficits over the period (1974 to 2008) are entirely cyclical and reflect the fact that rising unemployment drove the automatic stabilisers sufficiently against the contractionary bias in the budget to generate the deficits.

You can also see that the budget surpluses in the recent years were structural. They were not driven by the commodity prices alone as the Treasury is trying to tell us. The previous federal regime was running hugely contractionary positions during this time and relying on the private credit binge for growth. This was an unsustainable growth strategy and the height of fiscal irresponsibility. We are suffering the consequences of it now.

It should also be apparent that the swing in net spending (from the structural surpluses) to a structural deficit (which will be required for sustainability to finance private net savings) will be huge. That is, if we seriously consider full capacity to be when every one has a job!

What this tells me is that budget deficit currently is way to small as a percentage of GDP. The structural budget that the Government is coming from was very contractionary.

While this exercise is simplified (to fit it into a quick blog) all the additional complexities that I might have put into the estimation of the structural budget balance would not really change much. The diference between my estimates and the Treasury’s (and the IMF and the OECD) lies in my assumption that full capacity = full employment = every one has a job who wants one at the current wage levels.

They try to con us by equating the full capacity position with the NAIRU (currently estimated – read “made up” – by the Treasury to be just over 5 per cent). Commentators will then start raving on that the budget is too expansionary when in fact it will likely still be contractionary.

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You will get deficits anyway

I was asked last night during a lecture I gave in Newcastle about the financial crisis whether the previous surpluses would have occurred if the household sector had not loaded up on debt as much. The clear answer is that Costello may have got away with one or two surpluses but eventually the fiscal drag would have been so great that automatic stabilisers would have sent the budget back into deficit with rising unemployment and falling output growth.

Randy Wray made the point that in the history of the US, every time the federal budget has been in surplus, a major economic downturn followed immediately and sustainable growth was only resumed once the budget returned to deficit.

Consider this graph. It shows the recent history of the Federal budget (in Australia) as a percentage of GDP (deficits – and surpluses +) and the official unemployment rate. If you ever wanted a mirror image here it is. Every time we have gone into surplus over this period, rising unemployment has followed. The recent surpluses lasted longer because for a time the spending gap was partially filled by the private debt binge. That was not a sustainable growth strategy and it has now unwound well and truly.

The point: you will get deficits whichever way you go. It is far better to have structural deficits and underwrite strong employment growth and low unemployment than to try to pursue surpluses and create the conditions where the cyclical swings (the automatic stabilisers) drag you back into deficit but in this case with high unemployment and falling employment growth. It is a no-brainer that the Government and most of the rest (politicians and commentators) don’t seem to understand.

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Saturday Quiz tomorrow!

The Saturday Quiz will be available tomorrow late afternoon some time.