"Cyclically-adjusted deficit" is not a macroeconomic concept

It shouldn't be, anyway.

Tyler Cowen says: "These cyclically adjusted measures are useful information and should not be discarded, but I don’t wish to use them as the sole or main or dominant source of information about the stance of fiscal policy."

I'm going to make a stronger claim. One I have made before.

Consider two countries. Both countries are identical, except:

Country A has an activist government, which likes to be seen as "doing something" when there's a recession. It rushes around passing new laws increasing government spending and cutting taxes whenever there's a recession.

Country B has a lazy government, which likes the idea of "fire-and-forget" fiscal policy. It passes a law before the recession, which ensures that government spending automatically rises and taxes automatically fall whenever there's a recession. Then it goes back to sleep.

Both countries have exactly the same levels of government spending and taxes during a recession (and during a boom too).

A recession hits both countries. The accountants measure the "cyclically-adjusted deficits" ("structural deficits") in both countries. They ask "under existing tax laws and spending laws, what would the deficit be if there were no recession?" They conclude that country A has a big cyclically-adjusted deficit, and country B has none.

But there is no macroeconomic difference between the two countries.

You cannot say that country A had a good "countercyclical fiscal policy", and country B didn't. They had exactly the same fiscal policy. They just implemented it in different ways.

A second example. Country C has a strong system of automatic stabilisers, including a steeply progressive tax system, but increases tax rates in a recession. Country D has a flat tax system, but fails to cut taxes in a recession. They end up with exactly the same taxes in a recession. C has imposed "austerity", and created a 'cyclically-adjusted surplus", and D has not. But there is no macroeconomic difference between the two countries' fiscal policies. C has sinned by commission; D has sinned by omission.

"Cyclically-adjusted deficit" is a political/legal concept. It is not a macroeconomic concept.

(There might be some important macroeconomic differences between those two ways of implementing fiscal policy: maybe automatic stabilisers work more quickly than activist policies; maybe automatic stabilisers give more certainty about the future and help stabilise expectations better. But you won't see those differences captured in the cyclically-adjusted deficit number.)

Update: what should replace it? Maybe deficit/GDPgap? Or percentage deviation from a cross-country regression of deficit on GDPgap? Crude, but simple. Still vulnerable to Tyler's obection that the gap between actual and "potential" GDP is a judgement call. But better than "cyclically-adjusted deficit", which makes the same judgement call about potential GDP, and then adds a lot of legal/political noise.

Comments

[Ralph Musgrave]

Nick asks “What should replace it?” How about this.
1. SOME DEFICIT is needed simply to keep the monetary base and national debt constant relative to GDP in real terms. (That’s first because GDP expands in real terms, plus inflation eats away at the real worth of the base and debt .) Call that “the basic deficit”??
2, it’s possible to have some deficit over and above the “basic deficit” which is entirely unjustified in that there’s no recession. Call that the “politicians buying votes” deficit. (Politicians love deficits because voters notice tax increases much more than they notice the effects of excess and unjustified deficit.)
3. there’s deficit justified by a recession. Call that the “recession justified” part of the overall deficit.
Have I introduced new and worthwhile nomenclature to economics?

[Oliver]

Isn't 'fiscal stance' sufficient?

[Scott Sumner]

Great post, it's a point I had never considered before.

The other problem is that the entire discussion generally assumes that fiscal policy is a tool that can be used, and monetary policy is not. Thus one objection to fiscal stimulus is that monetary policy should close the output gap, not fiscal policy. The defenders of fiscal stimulus respond that central bankers are too conservative to do their job, so we need to rely on fiscal stimulus. But (at least in the US), what evidence do we have that central bankers are less willing to do stimulus than fiscal policymakers? And without a plausible monetary policy counterfactual, all multiplier estimates are nonsense.

This is different from the question of whether fiscal policy is beneficial--it might be (using your belt and suspenders argument). What bothers me is that people used these cyclically adjusted deficit figures to try to estimate the "multiplier," without any plausible monetary policy counterfactual, even though our Fed has explicitly indicated that it tries to offset the effects of fiscal [typo fixed NR] policy (although it doesn't think it will fully do so.)

[david]

Credibly-promised-current-expected-path-of-future-fiscal-policy-adjusted-deficit!

[Jacques René Giguère]

But isn't structural deficit meant as " the deficit if nothing had changed in the numbers of the previous year"? That you actively or passively change your G and T doesn't alter this definitionnor make it meanless.

[Ralph Musgrave]

Contrary to Nick’s claims, the fact that country A expands its deficit in a DISCRETIONARY manner in a recession, while in B the deficit expands AUTOMATICALLY does not invalidate the concept “cyclically-adjusted” deficit. The fact that one house has a heating system that adjusts automatically to cold weather while next door the house owner adjusts the heating manually, does not invalidate the concept “extra Kwh burned due to cold weather”.

I suggest the real weakness in the “cyclically adjusted deficit” concept is that it fails to distinguish between its two constituent parts: the “basic” or “justified” deficit I referred to above, and the “politicians buying votes” or “unjustified” part.

[Nick Rowe]

Ralph: I always automatically subtract debt x inflation rate from the deficit. Then usually subtract debt x real growth rate too. That tells me if the debt/GDP ratio is rising or falling.

Oliver: but what do we mean by "fiscal stance"? Some people say it means "cyclically-adjusted deficit". I'm saying that's a bad definition of fiscal stance.

Scott: thanks!

Defining "fiscal stance" and "monetary stance" in a mutually consistent manner might be tricky. Imagine the "evil fiscal twin" of Scott Sumner, who defines "fiscal stance" as "tight/loose iff NGDP is growing less/more than 5%" ;-)

david: I'm not sure what that means.

Jacques Rene: you lost me. Setting aside G, I have always taught that CAD means "what taxes and transfers would be under current tax rates and transfer rules if income and unemployment etc. were at "potential"."

In the simplest case, with a proportional income tax system, the deficit is G-tY and the cyclically-adjusted deficit is G-tY*, where t is the current tax rate.

[david]

The difference is in this:

The accountants measure the "cyclically-adjusted deficits" ("structural deficits") in both countries. They ask "under existing tax laws and spending laws, what would the deficit be if there were no recession?"

But that's wrong. Obviously, future policy may change (and indeed would have to, for the examples to be equivalent). And it is the future-change-adjusted deficit that we are interested in, because that is what drives the solvency of a state with accumulated debt: investors take the future into account, not just existing tax and spending laws.

The accountant should, as bondholders do, anticipate what future tax and spending laws will be. Via market expectations of these, perhaps. Notice that even if the underlying political economy is that a future activist government will shrink during a future boom, if investors now don't think that, then the deficit has all the effects of a cyclically-adjusted deficit anyway. Therefore we should assess deficits by present market expectations of the future.

[Nick Rowe]

david: aha. OK. But you are talking about long run solvency, which is a totally different question. The "cyclically-adjusted deficit" concept is used as a measure of the stance of fiscal policy for short run macroeconomic demand stabilisation.

[Oliver]

but what do we mean by "fiscal stance"? Some people say it means "cyclically-adjusted deficit". I'm saying that's a bad definition of fiscal stance.

I don't know quite what 'cyclically-adjusted deficit' means. But I would say that fiscal stance covers all cases. A fiscal stance can be tight or loose, so as to deliver a balanced budget at full employment, e.g.. And it can be more or less sensitive to cyclical changes in GDP, depending how progressive taxes are and how broad the tax base is etc.. The cyclically determined budget outcomes might then necessitate adjustments in the stance to deliver a different outcome if so desired. So there are better or worse stances for any desired set of outcomes but, short of a head tax, deficits adjust to the cycle automatically anyway, so it's hard to speak of a cyclically-adjusted deficit as though the budget outcome were a 100% discretionary creature. In any case, the fiscal stance (the way i understand it) should tell you all you need to know.

[Scott Sumner]

There's a typo in the last line of my post. I meant "fiscal" [fixed. NR]

Nick, Yes, my evil twin might say that, but because there are approximately zero economists in the entire solar system who have publically advocated using fiscal policy to target inflation at 2%, I'm going to assume that my evil twin remains imaginary. People know at some deep level that monetary policy calls the shots, whether they admit that they know it or not.

[OGT]

I always thought the cyclically adjusted deficit was just the comparison of expenditures and revenue to potential, or smoothed GDP changes.

Here's an IMF paper on much the same topic:

http://www.imf.org/external/pubs/ft/tnm/2009/tnm0905.pdf

I think you're underestimating how important this measure is though, if done properly. Some countries/US states have very very pro-cyclical tax systems for example, Ireland, Spain, California, and China's local gov'ts are all very dependent on real estate transfers taxes. Real Estate is, of course, the most cyclical sector of the economy, so seemingly balanced budgets in boom times are deficits in waiting. (Some of which may be OK, but you need to have a good estimate of the actual cyclical swing to do actual budget planning),

[david]

@OGT: Reliance on smoothed GDP changes requires an assumption of stationarity in GDP. This is truer of some countries than others. If one is confident in stationary GDP then all this discussion is irrelevant, of course, since one knows the cyclically-adjusted GDP and therefore approximate tax base readily.

@Rowe - hmmm. Universally speaking the state must be spending 'more' than it was expected to, regardless of the underlying regime changes. The response to fiscal stance depends on what the fiscal stance net of expected level of recession was anticipated to be. This is true regardless of whether the state is automatic but the recession was unexpected, or the state is activist and the recession is also unexpected.

A state where the fiscal response is automatic or activist but the trigger is thoroughly anticipated becomes Ricardian and smoothed-out. We do observe this: government spending is seasonal. It skyrockets and then collapses at the end of every Budget year as departments seek to exhaust their allocated funds. Obviously markets do anticipate this and the seasonally-adjusted fiscal stance remains near-constant throughout.

[genauer]

Just a little German bitching:

How do you , Nick Rowe, and Scott Sumner feel about us Germans.
“Cyclical adjusted deficit” not as a concept, but “The law”, in the largest economic unit ever in the universe, the EU (European union) , as we know it : -)

Nobody here gives a hoot about anglo ivory towers, we have our Ordnungspolitik, we know it works, and we make it the rule to live by.

The real discussions were about 2 years ago, the crucial decision point some EU summit in December 2011. Final signoff, grudgingly, by French socialists, on the “fiscal pact”, a few weeks ago : - )

And now, 2 years behind the curve, you start moaning and bickering.

@Scott
For you that question too:
“Tell me one specific Krugman paper, and why you think it is good, in 2 or or 3 specific sentences”.
Nick Rowe and Noah Smith, and a couple of irish folks too, already tried their luck

[Jacques René Giguère]

Nick: wasn't clear as I was pressed for time.
What I meant that simply that for most people, structural deficit (as opposed to conjonctural) is wwhat it would be if the underlying situation( the numbers) haven't changed.
Genauer: Ordnugspolitik doesn't work. See: Europe, now.
When the economies of most of Europe ( and the turn of Germany is fast approaching)are destroyed and wild, uncontrollable political forces will unleashed themselves.
When the euro , though a project that made no sense but now have great symbolic value,has blown up.
When the most noble political and economic project in history ( prosperity and lasting peace at last for Europe) is discredited for at least a century.
And when the name of Germany is held in contemps for the policies they fostered.

What will be the victory of Ornungspolitik?

I love Germany. German is the second foreign language I learned ( though I never practiced enough and can't speak it anymore. I am dismayed at what is going on.

[DocMerlin]

Ultimately, there is no counterfactual that you can measure here without assuming a multiplier or something similar. It makes the whole exercise meaningless.

[genauer]

@Jacques

Ordnungspolitik is working. But it is no magic wand, it is not painless, and it takes time.

http://online.wsj.com/article/SB10000872396390443768804578036031454375510.html
“It is hard to overstate how much personal sacrifice is being experienced across Europe today. But these sacrifices would have been in vain if we were to waver now and fall for the miracle cures of debt mutualization, cheap money, fiscal stimulus and other soothing but toxic remedies.

Tackling a crisis of this magnitude is a long-term effort that requires stamina and patience. Temporary setbacks cannot be ruled out. There are more reforms to be made at the national level, for instance in the services and products markets. There are regulatory and supervisory lessons yet to be drawn from the financial crisis. Fiscal and economic policy, but also financial sector legislation and supervision, will have to become more integrated at the European level.

Underpinning and legitimizing these separate initiatives is an overarching effort to progress toward political union, deepening the political and institutional edifice that supports the European economic and monetary union.

But the crisis does not just bear lessons for Europeans. Like the laws of physics, the laws of economics apply to all of us. One universal lesson of our crisis is that confidence, in particular market confidence, does not bend and bounce back like a reed. It breaks. And when it does, it is very hard to repair.

The crisis should be a wake-up call to those governments in the Americas and Asia where public debt has reached levels not seen before. They must chart a credible path to fiscal reconstruction and then embark on it.”

When you take a closer look, all countries, which fare pretty well now, have gone through some crisis in the last 20 years.
The Scandinavians: Denmark, Sweden, Finland (oil rich Norway of course had it very easy), Netherlands, Austria, Germany.

But the SOCIAL COHESION carried them and us through it. We all have still pretty solid social standards, universal health care AND competitive industries / labor laws.
When you take the necessary, painful steps, to turn your country around, it takes 2 -4 years of rising unemployment, same here.
The one thing, that makes Germany actually somewhat unique, is that we addressed it RELATIVELY early on (I still remember my feelings of: why does it take so long, to do, what has to be done), therefore the pain was actually smaller than in Scandinavia, something we only appreciate in hindsight. And it was a leftie, social democrat, chancellor Schröder, who pushed Agenda 2010 through. The next election went to the conservatives, somewhat ironic, with Merkel even announcing VAT increases before it.

Spain is starting serious reforms just this year, Monti in Italy had to compromise, so far, on labor laws, and Italy has a pretty interesting political landscape. But we hope that bunga bunga Berlusconi will finally go to jail, and that will change things.
Of course it left some impression on people like me, when we search the global published opinion landscape, and you get the impression, it is all reasonable people, the overwhelming majority of media, the American economists, the financial press (Bloomberg, FT, etc), all mocking and condemning the seemingly bone headedness of just a few German only dinosaurs.
They have so many economics Nobel Prize winners, and we so few. I could not even recommend a book, describing Ordnungspolitk. So many people are threatening a replay of the 1930ties, if we don’t give in to all this nonsense, Eurobonds, never ending deficits, massive, permanent transfers. If people hate us, and don’t buy our goods anymore, we would be in deep trouble, and being right would not help us, we are a massively trading nation.
But then, taking a very careful look, engaging in several blogs around the world, and carefully listening and engaging in discussions, in fact a very different picture emerges:
Phelps: “Germany is right to ask for austerity”
http://www.ft.com/intl/cms/s/0/21d62aa8-d18f-11e1-bb82-00144feabdc0.html#axzz29AwYFOxC
“Chancellor Angela Merkel and Wolfgang Schäuble, her finance minister, are right to oppose fiscal and bank unions without political union. Without any teeth in such agreements, the nations now besotted with wealth, private and social, could use the loans and grants for financing more deficits and more entitlements – another round of corporatist excess – rather than for smoothing the way to fiscal responsibility.
Behind the differences of technical matters, however, is a split between those who want to go on with corporatism and Keynesianism, and those who want some approximation of well-functioning modern capitalism. What we are seeing is another battle in the war between these two world views.”

[OGT]

Jack, if you read the imf paper, method 2 is approximately a smoothed gdp to estimate "potential". Certianly better than assuming all deviations are changes in supply potential. If that was the case, IT rate target would be all the CB needed to do....

Nick: good response by Wren-Lewis

[genauer]

@Jacques, 2

Germany still is an extremely popular nation, place 1 or 2, see the annual BBC Survey. Despite all the socialist / financial center propaganda, Bloomberg, FT, Soros and the likes.

Chancellor Merkel has extremely stellar approval ratings:
http://www.pewglobal.org/2012/05/29/chapter-4-views-of-eu-countries-and-leaders/

“German Chancellor Angela Merkel is widely seen as the most effective national leader in dealing with the European economic crisis. Eight-in-ten Germans say she is doing a good job, as do about three-quarters of the French (76%) and two-thirds of the Czechs (67%), Poles (66%) and British (66%).

In Germany, Merkel is significantly more popular among older people than among the young, but in other European nations her appeal cuts across generations. Notably, there is no significant gender gap in her appeal. Her efforts are appreciated equally by men and women. In most countries, Merkel is popular across ideological lines, including support by 78% of Germans on the left.”
In all countries, except the notorious Greece, Merkel is way more popular than their own leaders.
Just not with special interest groups, radical unions, representing small, but vocal minorities.
When, in the history of all mankind, have you ever seen something like that?
We are not standing alone, not at all. Please read a Polish Foreign Minister, Sikorksi, calling for more leadership from Germany, lecturing Britain in his Oxford Speech, Vaclav Klaus critizing us somewhat for being too soft.
“Red engineer” Labor MP Jeroen Dijsselbloem “New Dutch finance minister promise cuts, tough line on euro zone”

http://www.reuters.com/article/2012/11/01/us-dutch-finmin-idUSBRE8A015020121101

I could go on with similar references for pages.

I say, that most people in Europe know, that the Scandinavian/ German model works better for the “normal” people, caring for all its people up from the very bottom, and not giving in to special interests. Having strong and disciplined unions, who are not as stupid as the American UAW, who need to bankrupt their companies, before accepting realistic wages. Unions, who have half the board seats, unions, who represent large majorities. The German “IG Metall” union has 2 million members, not by coercion with “closed shop”, but based on insight and solidarity. The American UAW, which had a monopoly of 90% of world car manufacturing in 1946, now controls a mere 230 thousands.

Debauching our common Euro currency would not hurt people like me, along the lines of Scotts NGDP, at first. I have very little assets, which are inflation sensitive. But tearing up the social fabric, as the consequence, would destroy way more important treasure I have, living in a socially stable society, with justice for all.

[Nick Rowe]

Genauer: This post is not about Germany, or Paul Krugman. Stop.

[genauer]

Nick,

it is the third time.

People make gross allegations against Germany, personal insults, and it does not bother you. Only when I refute the accusations, after waiting for 2 or 3 days, item by item, with supporting evidence, then it disturbs you.

I find this pattern disturbing.

[Nick Rowe]

genauer: Nobody mentioned Germany, until you did. Halt.