More on the Structural Deficit

It seems that the structural balance is going to be the primary target of fiscal consolidation in next week’s supplementary budget, thanks in part to the efforts of some of the contributors to this site, notably Philip Lane and Patrick Honohan. However, despite its obvious intellectual appeal, it is problamatical from an operational point of view: it is very difficult to estimate reliably. As a result, there is a fair amount of variation in current estimates of it for 2009, ranging from the lower bound of the ESRI’s 6-8% of GDP range to John McHale’s 9.6% in his post of March 30th.

Accordingly, all estimates of the structural deficit need to be treated with some caution. I think this is especially true of those that imply that a very small fraction of the prospective overall deficit for 2009 is cyclical in nature.

As any fiscal anorak will know, but perhaps not many normal readers, there are two main planks in the estimation of the cyclical (and hence the structural) element of the deficit: (i) the output gap and (ii) a measure of the sensitivity of the budget to the output gap. A word on each.

The output gap. The European Commission estimates that Ireland’s potential growth rate will be negative to the tune of 0.4% this year. This is surely a much lower figure than it is reasonable to use to represent the economy’s potential growth over the medium run. The ESRI’s latest estimate of the latter is 3%. Which one to use in calculating the output gap? If the former, it will mean a relatively small output gap and a correspondingly small estimate of the cyclical element of the deficit. Philip Lane has opted for this approach (see his post of March 26th). However, it can be argued that since the elimination of the structural deficit is properly regarded as a medium-term objective, it is the medium-term potential growth rate that should be used to estimate the output gap. The result is a bigger estimate of the output gap and a bigger cyclical component in the deficit.

The sensitivity measure. It has become commonplace to use 0.4 as the cyclical sensitivity co-efficient, implying that every 1% point change in the output gap changes the budget deficit by 0.4% of GDP through the operation of ‘automatic stabilisers’. The 0.4 is an OECD figure estimated on the basis of data for the 1980-2003 period. It is built up from a set of tax and spending elasticities with the overall tax elasticity computed as a weighted average of the elasticities of four different categories of tax, where the weights reflect the share of each in total tax receipts over the 1995-2004 period. An obvious point about this is that the composition of the 2008/09 tax take is different from that of this historical period.

A more important question is whether the elasticities so estimated accurately reflect the relationship between revenue and GDP in current circumstances. A case can be made for the proposition that the cyclical sensitivity of at least some categories of tax is higher than usual in the current recession. A very interesting comment from Niall on Patrick Honohan’s ‘Credit card sales’ post of March 31st sepaks to this point. He warns of a triple whammy undermining this year’s CT receipts, comprising (i) 2008 preliminary tax refunds; (ii) losses set back to 2007, and (iii) no preliminary receipts for 2009. In the OECD model, CT receipts are estimated to have an elasticity of 1.3. Does this chime with what’s happening out there?

To illustrate the difference that the above two points can make, consider the following arithmetic example. Assume a zero output gap in 2008, a volume decline of 8% in GDP and an overall budget deficit of 12 % of GDP in 2009. Now decompose that deficit into its cyclical and structural components using (i) a -0.4% potential growth rate and a sensitivity co-efficient of 0.4 and (ii) a 3% potential growth rate and sensitivity co-efficient of 0.5 (this being close to the OECD estimate of the EU average, by the way). In the first case, the cyclical/structural split is 3%/9%; in the second it is 5.5%/6.5%.

6 thoughts on “More on the Structural Deficit”

  1. Jim, thanks for this estimate the two components of the deficit (and for your earlier reference to my attempt to estimate Okun’s Law for Ireland under very different circumstances).
    On the decomposition of the fiscal deficit, I think it worth repeating Colm McCarthy’s pithy note, lest it get buried under more recent posts:

    “With both labour supply and capital stock endogenous, concepts like potential output get very slippery. It is conceptually, never mind empirically, difficult to disentangle structural and cyclical components of the deficit in these circumstances. The smaller the economy and the more open, the harder it gets. It’s not just that Irish net migration has swung round recently, so has the BOP and the counterpart on the capital account. Potential output as conventionally measured is policy-influenced. Philosophical quagmires abound.”

    The mention of philosophy reminds me of St Augustine’s famous prayer: da mihi castitatem et continentiam, sed noli modo. There is a risk that the distinction between the two sources of the deficit will be used as an excuse for procrastination.

  2. Jim, timely post. Since I seem to have the dubious honour of having the high-end estimate of the structural deficit, I should probably clarify. All I do is take the Commission’s estimate in the stability programme and adjust for (i) the apparent slippage in the overall deficit (9.5% to 12%; (ii) and the reduced forecast for GDP growth (-4% to -6.5%).

    I hold no candle for the Commission’s analysis, and agree their estimate of potential output looks very pessimistic. I also agree with Brendan that any estimate of potential output or the structural deficit in the current environment must come with very wide error bands. (One challenge here is that there are likely to be both level and growth effects on potential output given the significant restructuring of the economy.)

    My point in the last post was just that it is important for the government and the commission to be on the same page if the structural-cyclical distinction is to be made central to the fiscal plan. Otherwise there is likely to be yet more confusion, leading to further deterioration in government credibility.

  3. Might as well use the latest projections given today’s exchequer returns and the minister’s revised growth outlook (’09 deficit = 12.75% of GDP; ’09 real GDP growth = -6.75%).

    Updating the Commission’s projections: Starting from a 8.1%/1.4% structrual-cyclical split with a total deficit of 9.5% and a growth rate of -4.0%, the new split with the revised numbers is 10.25%/2.5%. (This uses the standard budget sensitivity parameter of 0.4 that Jim fairly questions.)

    The adjustment required to hit the original structural deficit target is now 2.15% of GDP.

  4. @John
    So : your best guess, and this is a re-visit to macro for me, is that we are now on 10% structural – thats what, 17b…
    So to make real indents we need 9-10b next tue…which aint gonna happen. HMOF….

  5. As a non-economist I wonder if all these projections and estimates are making an error analogous to dividing by zero.

    Mathematicians define division for every real number except zero. It’s possible to write a computer program to perform division that does not check that the divisor is non-zero but the person running the program has to do this check manually first. In other words the program makes certain assumptions that have to be verified externally.

    Similarly with projections and estimates in the current circumstances. The banks are not working anything like normally, for example. People don’t absorb the figures in the various media reports about the economy but they get the message: things are bad, they are getting worse and they will continue to get worse for some time. The pronouncements of economists – and others – from their projections and estimates affect people’s behaviour and are dragging the economy down. (That’s a straightforward comment and not an attack on anyone.)

    I like the mention of “error bars”. It’s not a concept you will hear in the media. I would say that the current circumstances are so unusual and that so many of the assumptions underlying quantitative economic analysis and models are invalid that it would be better either to abandon quantitative analysis temporarily or else to qualify its results very heavily when presenting to the general media. And good luck with the latter!

  6. @Brian Really not my estimate, just a mechanical update of the Commission.

    In terms of the adjustment in billions, I assume a nominal GDP of 167.2 billion in 2009 (a 10 percent fall from 2008). The total deficit would be 21.3 billion. The structural-cyclical split would be 17.1/4.2.

    If we return to the original goal for this budget — correcting for the slippage relative to the Stability Programme — but use a structural deficit rather than total deficit target, the required adjustment is 2.15 percent of 167.2 billion, or 3.6 billion. The question then is: How much of the additional structural deficit reduction should the government do this year? I still think the government should tread carefully here, but I do see it is big gap to close — over 7 percent of GDP by 2013 to hit the 3 percent of GDP target — so I understand why others believe we should get on with the job. One alternative is to front load the strucural deficit reduction, but do a partial offset it with temporary stimulus measures (there is some of this in the expanded Fine Gael plan).

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