The Structural Deficit

The latest on the massive General Fund deficit from CalculatedRisk harkens back to the writings of by E. Cary Brown in the 1950’s where he noted that the actual deficit depends both on the state of fiscal policy and the size of the GDP gap. During a return to full employment, it is possible for the actual deficit to decline even as the structural deficit rises.

If one goes back about four years, the argument that part of the deficit was attributable to being below full employment was quite plausible. But when I heard Robert Novak declare that we had a structural surplus during a Capital Gang episode aired late in 2002, I had to question where he got such an absurd notion. Later I realized that Novak was relying on The Deficit Dance where Lawrence Kudlow starts with the unified deficit and then tries to estimate the GDP gap by what would have been a sensible procedure had he averaged the 6 to 7 quarters of annualized GDP gap figures rather than summed them. For anyone to think the GDP gap was $2 trillion in 2002 is beyond dumb. Of course, the current archived version was editted to read:

Cumulatively, over the past two years, the loss of potential GDP comes to $1.95 trillion — a considerable amount.

But even this figure is not valid as his own procedure of estimating the GDP gap would have produced a figure that was less than $400 billion per year. Also note that Kudlow did not extend this edit down to the next paragraph as he took his 18% taxrate and multiplied it not by $1 trillion but by almost $2 trillion to get his alleged $350 billion plus per year loss in tax revenues.

After one’s head stops spinning at all of this Kudlow Konfusion, let’s ask what is the GDP gap today? Some economists argue it is zero, which would mean the structural deficit equals the current deficit. A few of us think there is a small output gap, but that would still mean a large structural deficit that is not going to be closed by fiscal stimulus. Now you might wonder why CalculatedRisk and I would argue for long-term fiscal restraint given the possibility of an upcoming recession. Actually, I’m hoping for a return to the aggregate demand policies of 1993 where the fiscal authorities convinced the Federal Reserve to lower interest rates with a promise of gradual fiscal restraint. Alas, the current macro-mix is just the opposite.