Structural Deficits vs. Cyclical Deficits

Charles N. Steele
 
Issue CCXXXVI - February 15, 2010
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Now there's a catchy title for an article, almost guaranteed to make the reader's eyes glaze over.  And yet the distinction is of the greatest importance if we hope to solve the problem of America's burgeoning national debt.  Here's a quick primer on the difference and why it matters.
 
The federal budget deficit is, of course, the difference between federal revenues and federal spending in a year; the federal government must borrow this amount.  There are two components of the deficit: structural and cyclical. What are these?  The structural component represents the shortfall from the federal government conducting "business as usual" when the economy is exhibiting normal economic growth.  The cyclical component represents shortfalls attributable to recession: decreased tax revenues and stimulus spending.
 
The cyclical component is dramatic; it has exploded the deficit as a share of GDP, and it has grabbed everyone's attention.  But it also misleads. As soon as (if?) economic growth returns to normal, the cyclical components go to zero.  Except for the additional interest payments they require, these have little effect on the long-run fiscal position of the U.S. government.  On the other hand, "normal" involves structural deficits that are entirely unsustainable: assuming no new spending programs, no fix of the Alternative Minimum Tax, and no renewal of the tax cuts ushered in by George W. Bush -- the CBO's "extended baseline scenario" -- our annual outlays on Medicare, Medicaid, Social Security, and debt service alone grow to exceed annual revenues over the longer run. And under the CBO's more realistic "alternative scenario," in which discretionary spending grows as fast as GDP and the AMT is "fixed," deficits explode much sooner.  Keep in mind that unlike the cyclical component, these structural deficits don't fade away; they grow faster and faster.  (See the CBO's Long Term Budget Outlook for details.  The chart on page 6 gives a good summary, and the graphic of the exploding debt on page 5 adds drama.  I recommend familiarizing yourself with this document.)
 
This shouldn't make your eyes glaze over -- it should make your hair stand on end.  Even an unrealistically conservative analysis of structural deficits tells us that the equivalent of national bankruptcy is in our future, if we maintain business as usual.  For all the grave doubts I have about TARP, ARRA, PPIP, and all the other "stimulus" programs the Bush and Obama administrations have introduced, these are (I hope!) short-term cyclical programs that will fade away before long.  In fact, there's nothing unprecedented in our current cyclical deficits: in recent history, when a country undergoes a banking crisis its national debt increases 86% on average, according to research by economists Ken Rogoff and Carmen Reinhart.  (Full reference on request.)  Our real danger is from the growing structural deficits, and there are no easy fixes for these.
 
President Obama's proposed freeze on non-military discretionary spending is a nice gesture, but not much more than that, since this essentially puts us on the "extended baseline" path.  It's just a slower a road to ruin.   Congress had better start actually tackling the structural imbalances, and soon.


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