The structural deficit is the one that would exist, if output were at its trend level. This means that its measurement depends upon three unknowns: the size of the output gap; the response of spending to moves in GDP; and the response of revenues thereto. All these are uncertain, as the OBR acknowledges:
Forecasts of cyclically-adjusted aggregates are subject to particular uncertainty, as they depend on projections of the current position of the economy relative to trend. They also rely on analysis of the effect of the economic cycle on borrowing from previous cycles, which may not hold in the future.To get a rough idea of these uncertainties, let’s do some sums.
The OBR uses the Treasury’s procedure (pdf) for estimating the structural deficit. This says that a 1% output gap, after two years, causes current spending to rise by 0.5% of GDP and causes revenues to fall by 0.2 per cent of GDP.
Now, the OBR estimates that the output gap was 1% in 2008-09 and 4.1% in 2009-10, and that cyclical adjustment reduces the deficit from 7.6% to 5.3% of GDP.
But let’s say the output gap is one percentage point larger in both years, and that revenues and spending are each 0.1 percentage points more sensitive to the output gap.
These small tweaks reduce the deficit by a further 1.5% of GDP this year, to 3.8%.
This means that the fiscal tightening which Labour put in place is sufficient to cut the cyclically-adjusted deficit to just 0.1% of GDP by 2014-15, on the OBR‘s numbers. Which eliminates the need for a large fiscal tightening.
There’s another reason I don’t like the idea of a cyclically adjusted budget balance. It’s that, as Ralph says, the budget balance depends upon the savings of the private sector.
To see the problem, imagine output were on trend - that is, higher than it is now. This could be because the private sector goes on an investment boom, and its investment exceeds savings. If so, the public sector will have a surplus, as the counterpart of this. By definition, this will be a cyclically adjusted surplus. However, it could also be that output is strong because of strong overseas demand and UK firms save the profits generated by this. In this case, the private and foreign sectors together might have a financial surplus, so the government will have a cyclically-adjusted deficit. But on both cases, ex hypothesi, fiscal policy is the same.
Cyclical adjustment, then, does not necessarily tell us whether fiscal policy is loose or tight.
So, could it be that the notion of a structural deficit is a pseudo-scientific concept, intended to give a cloak of respectability to what is, in essence, a narrowly political desire to cut public spending? For more on this, see this paper by Randall Wray and Yeva Nersisyan.