Decomposing the deficit: structural, cyclical, and the fiscal impulse

Against a still struggling recovery, and continuing weakness in state revenues, talk in Washington is turning to cutting back. That may sound strange, but hear us out.

With the Obama administration released its proposed 2011 budget last month, a lot of attention has rightly been paid to the ginormous deficit—its possible corrosive economic effects and the possible difficulties in funding it. But what’s lost in those worries is what’s going to happen as the stimulus program expires.

Specifically, after the most fiscally stimulative budgets in modern history, barring major changes, policy is about to turn much tighter. 

Structure of the Deficit

The federal deficit can be thought of as having two major components, structural and cyclical. The structural deficit is what the balance would be were the economy at full employment; the cyclical component is the contribution that comes from departures from full employment, i.e., the state of the business cycle.

The graph below shows changes in the structure of the deficit from 2007 through 2018. Sometimes the cyclical component is positive, lessening the deficit (as was the case in 2007); sometimes it’s negative, as it is most other years:

(These estimates come from the Office of Management and Budget, as part of the President’s budget for 2011. Despite that authorship, the estimates look cautious to us. They define full employment as an unemployment rate of 5.5%, and we don’t see the economy returning to that level until 2017. And even if they’re optimistic on magnitudes and the longer-term trend, they’re probably not wrong about the direction of things over the next couple of years.)

The best way to isolate the policy effects of changes in government spending is to look at the cyclically adjusted balance. If the deficit passively swells because of recession, that’s just the so-called automatic stabilizers switching on. But if policy adds to it, through spending increases or tax cuts, then it becomes actively stimulative. 

The table below shows OMB’s estimate of the total budget deficit through 2018, and we are concentrating on the next few years.  In fiscal 2010, the total budget deficit is 10.5% of GDP, 3.2% of it the result of the recession and 7.3% of it structural, or from policy. That’s up from a deficit of 9.9% of GDP in 2009, 2.4% of it cyclical and 7.6% of it from policy. In other words, while the 2010 deficit is larger than 2009’s, the main reason for that is cyclical, not structural, since there’s less stimulus and bailout spending coming this year than last. Going forward, the structural deficit is projected to continue shrinking—to 5.1% of GDP in 2012, and 3.0% the following year. 

The Fiscal Impulse

Changes in the structural budget balance are sometimes called the fiscal impulse, shown in the right column. The decline in the structural deficit from 7.3% of GDP in 2010 to 5.1% in 2011 results in a contractionary fiscal impulse of 2.2% of GDP. Both the OMB and the CBO try to separate the cyclical and policy contributions to the deficit. The CBO’s number start in 1962 and end in 2011, and the OMB’s run from 2007 to 2017. If we splice the OMB and CBO series together, which is only slightly reckless since they’re pretty similar when they overlap, this is one of the starkest episodes of fiscal tightening in the last five decades, exceeded only by the 3.1% shift in 1969. A recession began in December 1969 and continued through November 1970. The second-biggest tightening was in 1987, the year of the stock market crash, which was followed a little later by a long period of sluggishness. 

Of course, the fiscal impulse can be stimulative. By the CBO’s measure, the 2009 impulse was expansive to the tune of 5.9% of GDP; by the OMB’s, it was 4.5%. These numbers are three or four times earlier maximums, like those of 1983 or 2002. And it’s not unreasonable to conclude that what economic recovery we’ve seen since mid-2009 is the result of this massive stimulus. This is apparent not only at the abstract macro level of budget numbers—it’s visible in specific cases, like the effect of cash-for-clunkers on car sales (which ebbed when the program expired) and the effect of federal support on the housing market (there would simply be no mortgage market without Washington’s support). So what is going to happen as the Fed’s purchase of mortgage securities ends in March? As the stimulus spending declines to a trickle

According to a simple regression, the fiscal impulse has an almost one-for-one influence on GDP growth. (See graph below.) So next year’s drag of 2.3% of GDP implies a brake on growth almost that large. Of course, fiscal policy, while important, is far from the only influence on growth; the regression’s r2 is .10, suggesting that it explains about 10% of the yearly variation in GDP growth (though from eyeballing the graph, we see that the extreme cases seem to matter most). That’s not beanbag, but it still leaves a lot to be explained.

A stronger influence on growth is the change in nonfederal credit; as shown in the graph below, it explains about 18% of the yearly variation in GDP growth. Together, the two explain close to 30% of the yearly variation in GDP growth. Putting the two together suggests that we’d need a very strong growth rate of 7-10% in nonfederal credit this year and next to offset the fiscal drag. We’ve only come close to that in two years out of the last 50. So we’re back to a dilemma we’ve identified many times: it looks like GDP growth needs a major revival of private credit expansion—but is that possible or even desirable?

Given that 70% of GDP growth remains unexplained by these two variables, we don’t mean them as literal projections. But it does offer support for fears that since the recovery was driven by fiscal stimulus, once that’s gone, we could be in trouble again.

In our issue of May 7, we wrote about the IMF’s  study of 122 recessions in 21 “advanced” countries since 1960. They found that downturns associated with financial crises are far longer and deeper, and recoveries slower and weaker, than those that aren’t financially driven. Here’s a close-up of the behavior of interest rates, stock prices, inflation, and employment in the four years after the onset of the crisis in 15 major financially driven recessions identified by the IMF. (See notes below)

In a nutshell, we found that on average, interest rates and inflation generally decline for the full four years; stock prices rise steadily, though not explosively, after a two-quarter decline; and employment falls for about three years before beginning a weak recovery.

GDP experiences are quite varied, with some countries experiencing sharp, sustained declines; others, brief, sharp declines followed by a strong recovery; and still others, extended periods of stagnation. Those disparate experiences produced a very misleading “average” line, so we are not providing a GDP graph. But despite those contrasting GDP patterns, almost all countries suffered from a very weak job market for several years after the financial system hit a wall.

Comparing recent U.S. experience to the average yields the following conclusions. Interest rates, inflation, and stock prices are all down much harder than the “typical” experience. This suggests that interest rates are probably not at risk of rising sharply, but we’re almost certainly past their bottom; stock prices, even with the recent rally, are not acting with outlandish exuberance; and inflation isn’t much of a risk for some time to come. Employment, however, is tracking the average very closely, suggesting that while the worst of the job losses are probably behind us, we’ve got another year and a couple of million to go.

Interest rates: down

Although financial crises typically come with a huge fiscal cost, as revenues sag and bailout expenditures rise, interest rates on long government bonds tend to decline steadily throughout the four year period we studied. Rates fell in 12 of the 15 examples over the first 8 quarters following the crisis, and 13 of 15 over 16 quarters.

Stocks: mostly up

Stock prices do surprisingly well in financial crises, after an initial spill. Actually, prices tend to decline over the year leading up to the crisis (about 4–5% on average); the post-crisis leg down is sharper but shorter than what preceded it (about 12%). But after that decline, stock prices tend to rise, though at far from a barn-burning pace—only around 5% a year.

Inflation: down

Though a lot of market participants expect that the financial bailout will ultimately prove inflationary, the history of financial crises suggests otherwise.

Employment: down hard

Deep, sustained declines in employment are almost universal following financial crises. If these averages hold, we’re about two-thirds of the way through the contraction in numbers, and not quite that far in time.

Notes:

In the four graphs, the line labeled “average” is the mean of the 15 financially driven recessions identified by the IMF, with the quarter of the crisis’ onset set to 100. The line labeled “U.S.” is the recent experience of the United States, with the onset of crisis set to the third quarter of 2007. Horizontal axis represents quarters before and after crisis onset (“C”).

These are the crises the IMF reviewed:

There's no shortage of reasons to worry about the health of the U.S. dollar: a still-huge trade deficit, a huge and swelling budget deficit, pervasive credit troubles, a serious recession that may linger, the threat of capital flight, etc. etc. Should we be worried about a currency crash?

That question is ambiguously phrased. It's quite possible the dollar could crash. But how bad would it be if it did? A surprising answer comes from a recent study by Federal Reserve economist Joseph E. Gagnon. The title lays out a broad hint: Currency Crashes in Industrial Countries: Much Ado About Nothing?. Gagnon's answer is basically, yeah.

Gagnon looks at 19 episodes of sharp currency depreciations-15% or more over four quarters-in 20 industrial countries since 1970. Factors that caused the crashes include inflationary policies, large current account deficits, capital outflows, and rising unemployment rates. Sometimes one factor was enough to cause the slide, sometimes it took several. But his surprising finding is that crashes were followed by poor outcomes-slow GDP growth, rising bond yields, and falling equity prices-only when inflationary policies prevailed. But the currency crash seemed not to contribute to poor outcomes-if anything, they mitigated them. The inflation did the damage, not the currency troubles.

The greatest danger from a currency crash came when the central bank was pegging a specific currency value despite inflationary policies. If the exchange rate is flexible or floating, there's considerably less trouble.

It's important to note that an inflation must be underway, and not merely expected, for a currency crash to be truly damaging. The threshold level of inflationary risk is a rate that's more than two standard deviations above the 20-country average, which works out to 7.2 percentage points.

Gagnon also finds that devaluations can successfully stimulate GDP growth and improve the foreign balance with little effect on inflation. He concludes: "Non-inflationary currency crashes uniformly had good outcomes: GDP growth was average to above average, bond yields fell, and real equity prices rose."

We're not conspiracy theorists, sad to say, but a word on what this paper might mean, aside from its interesting conclusions. There must be talk within the Fed about what would happen should the dollar fall hard-and maybe even if such a devaluation might be a good move for the U.S. Though no central banker or finance minister would ever let on that he or she is thinking this way, you can imagine the temptation. And from all this we'd conclude: avoid betting the farm on dollar strength. But if you lead a dollar-denominated life, you have little to fear from a devaluation. Things might look a little different in Beijing, but that's another story.

Dramatic slides in housing prices, auto sales, and oil prices have caused—need we point out?—tremendous turmoil over the past year.

We were out in front on all three (click to enlarge):

Auto Sales
 

Oil Prices
 

Housing Prices

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Arguing about performance-based pay is running neck-and-neck with grousing about bonuses, whether they be too big or too small, among popular topics this holiday season. In their upcoming paper, “Give & Take: Incentive Framing in Compensation Contract,” Judi McLean Parks (Washington University in St Louis) and James W. Hesford (Cornell University) test out their hunch that certain compensation packages may be linked to rising fraud, losses from which are currently estimated by the Association of Certified Fraud Examiners to total something like $994 billion annually.

Since compensation packages are considered a central tool in managerial control systems, managerial accounting research has long taken an interest in how compensation packages influence behavior.  A primary foundation of such research is agency theory, a model that assumes agent and principal are self-interested, but in divergent goals, that agents will shirk, “if necessary, [with] guile and deceit,” and that principals will attempt to control agents through monitoring or by aligning the interest of the agents with their own.  In theory, performance-based compensation systems are one way to accomplish the latter.  This may have worked well at GM in the 1980s, when line-workers were put on performance-based pay, so that when GM did well, they did well, but when the agents themselves are reporting the results, such contingency packages may instead encourage financial mismanagement and deceit.

In an effort to supplement empirical studies of performance-based pay, and to include penalty-contingencies, which are actually quite common, McLean Parks and Hesford undertook a controlled study.  Rather than the obvious choice of rats as participants, the authors brought in a random sample of students, paying them for solving anagrams under three compensation packages: flat salary, performance-based bonus, and performance-based penalty.  Each student was given a package with instructions, a “high-quality attractive pen” (keep your eye on these), and self-evaluation forms. Once they turned in the self-scored performance sheets, they threw away their actual work, allowing plenty of opportunity for fraud.

Basic results: those receiving flat salaries were the most honest in their reporting, those on bonus-contingent schedules were less honest, and those on penalty-contingent schedules were the least honest.  Even worse, when no ethics statement was signed, those on penalty-contingent pay were three times as likely as those on salary, and twice as likely as those on bonus-contingent pay, to steal those attractive pens.

The authors unearthed a concern about the use of ethics statements, such as the attestations all CEOs must sign under Sarbanes/Oxley.  Although, overall, 46% of those who did not sign such statements stole their pens, and only 29% of those who did sign statements did not “misappropriate assets,” the details are more complicated.  Those facing performance-based penalties were more likely to misrepresent their performance if they had signed such statements than if they had not. The authors suspect that the existence of the statements themselves suggested to the agents that the principals were weak on apprehending fraud. Why else would they be required to sign such statements?

McLean Parks sums up: “For years we have touted the basic mantra of pay for performance because that's the way you get the best performance. Maybe you get the best performance reported, but what's the underlying performance?"

Not really in the holiday spirit, but you can read the full study, still under review, here:

https://www.business.utah.edu/humis/docs/organization_962_1224879507.pdf