From Nick Rowe

by on November 3, 2012 at 1:19 am in Economics | Permalink

“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 objection 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.

The link is here.

DocMerlin November 3, 2012 at 2:29 am

Sigh. Its all bogus anyway, because there is no counterfactual that you can measure without assuming a multiplier, anyway.

Andrew' November 3, 2012 at 5:58 am

It’s funny that these folks must think we think that it really works and don’t want it anyway. Do economists try to purge the question of “what are we getting for our money?” or is just a shortcoming of their models? Goosing GDP would be first-run successful if it actually goosed GDP, but only ultimately successful if it did so in the sustainable direction (i.e. the opposite way from how they chose to goose it the entire prior decade). That is what I doubt they can do.

Andrew' November 3, 2012 at 5:54 am

Well-explained. Why do people think it is important to know precisely what the deficit is?

DocMerlin November 3, 2012 at 9:16 am

Part of the problem is that inflation in the medium of account screws with internal accounting.

Brian Donohue November 3, 2012 at 11:15 am

What should replace alchemy?

DocMerlin November 3, 2012 at 11:45 am

Crawfish with a side of fried okra.
No, in more seriousness, I don’t think there is an answer. This is like the macro equivalent of the socialist calculation debate. Any macroeconomic policy has the problem that whatever the government tries to target or measure will end up being useless.

Dave Backus @ NYU November 4, 2012 at 9:26 am

Like you, I’m at least as concerned with potential and gap measures. But on govt accounts, there’s an analogous issue with corporate accounting. GAAP allows for all kinds of adjustments and projections of raw numbers, which you might think of as similar in spirit to adjustments for the state of the economy in government accounts. My colleague Baruch Lev thinks that, on the whole, these adjustments reduce the information value of financial statements. Could the same be true of government accounts?

One example:
http://people.stern.nyu.edu/blev/Documents/Usefulness%20of%20Accounting%20Estimates.pdf

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