It’s Important to Distinguish Between Short-Term Cyclical Deficits and Long-Term Structural Deficits

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Thursday, July 27, 2017
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25 Fiscal Lessons

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Not all deficits are created equal.

In designing policy responses, it is important to distinguish between “cyclical” and “structural” deficits.

Cyclical deficits are caused by a weak economy. Recessions drive down government revenue because many workers and businesses are no longer earning as much taxable income. At the same time, government spending rises because more people need assistance through programs such as Medicaid, unemployment benefits and food stamps.

In budget parlance, these are known as “automatic stabilizers” because they help to maintain demand in an economy that does not have enough of it to keep growing. These automatic stabilizers produce a temporary, or cyclical, increase in the deficit. Once the economy recovers, tax revenue and government spending on assistance programs should return to normal levels.

If government spending exceeds tax revenue even when the economy is strong, however, then the deficit is structural. Unlike cyclical deficits, structural deficits reflect a chronic problem that must be addressed through significant changes in tax and spending policies. The most effective policy changes are those affecting permanent law, such as entitlement programs and tax provisions. With structural deficits, one-time spending cuts or temporary tax increases may help to relieve the pressure but cannot solve the long-term problem.

For example, following the 2008 financial crisis, deficits skyrocketed for cyclical reasons. Deficits were further increased by stimulus measures in the American Recovery and Reinvestment Act that Congress passed in 2009. By the end of Fiscal Year 2010, when cyclical deficits reached their peak, the total deficit had swelled to $1.3 trillion (or 8.7 percent of GDP), up from $248 billion in 2006 (1.8 percent of GDP), the last year in which automatic stabilizers reduced rather than increased the deficit. The public, increasingly alarmed, demanded that policymakers act to curb these deficits.

Bar graph of deficits

 

While this was a natural reaction, there was a sound economic case for the higher deficits. Well-targeted deficits designed to stimulate an economy in free fall can benefit the country’s economic health both in the short and long term because a shrinking economy leads to a higher debt-to-GDP ratio even when the budget is balanced. In FY 2010, over half of the deficit was due to stimulus measures that would dissipate as the economy recovered.

The real problem has always been over the long term. A temporary spike in deficits to combat a short-term national emergency is reasonable, but a national debt that consistently grows faster than even a healthy economy is not sustainable.

As the economy recovered from the recession, policymakers should have put more focus on addressing the drivers of the nation’s structural deficit. Instead, the vast majority of deficit-reduction legislation passed in the years since the recession has been concentrated on the parts of the budget that were already shrinking relative to the size of the economy.

Even assuming a strong economy with no cyclical deficit, current policies will mean structural deficits and a steadily rising debt-to-GDP ratio for as far as the eye can see. Eventually, the debt burden would become too great to bear. Although it is impossible to say exactly when that would happen, it would be foolish to risk finding out.

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