Misusing cyclically adjusted budget deficits

Chris Dillow alerts us to new claims that the UK government’s finances were in a terrible state before the financial crisis. Latest estimates from the IMF and OECD put the UK’s cyclically adjusted budget deficit in 2007 at around 5% of GDP, and the usual suspects have used these numbers to justify the theme that the Labour government was grossly irresponsible in fiscal terms before the recession. Chris explains why this might be quite acceptable to offset surpluses being run in the private sector. However as these figures appear to contradict what I argued about the Labour government’s fiscal record in this post, I want to explore a little bit where this number comes from.

The actual budget deficit in 2007 was just under 3% of GDP. As I argued in that earlier post, somewhat larger than the deficit required to keep debt to GDP constant, and therefore larger than it should have been, but not outlandishly so. The debt to GDP ratio in 2007 was much the same as when Labour took office ten years earlier. So to get a cyclically adjusted deficit of around 5% from an actual deficit of below 3%, the IMF and OECD must be assuming that 2007 was a boom year for the UK economy. That is exactly right – the OECD now estimates that UK output was 4.4% above trend in 2007.

Funny how it didn’t seem like that at the time. Indeed, the OECD in 2007 thought that the output gap that year was about zero, which was pretty much the consensus estimate. In which case the cyclically adjusted deficit would be much the same as the actual deficit. So what is going on? Why have the OECD and IMF changed their minds so radically about the state of the economy in 2007?

The answer, of course, is what happened after 2007. This was not just the recession, but the lack of recovery thereafter, and the absence of firms today saying they have spare capacity. I discussed the case of disappearing UK potential output (the ability or desire to produce output if demand is there) in this post. It is the same issue as our apparently poor productivity performance since the recession, which the longer it continues looks less like a temporary cyclical decline.

Now the capacity to produce output does not evaporate overnight. Capacity depends on three main things: capital, labour and productivity. Earthquakes aside, machines that could produce output yesterday can still do so today. The labour is still around, which is why we have high unemployment. Productivity is about how efficiently we use labour and capital to produce output. Once again, productivity should not fall overnight: we don’t just forget how to produce things efficiently. But the growth rate of productivity can fall to very low levels, if no innovation is taking place.

But even if productivity growth slowed dramatically after 2007, it cannot explain why apparent productive capacity is so low today. So if we believe productivity is really so low today, it must have started slowing down before the recession. In other words, productive capacity in 2007 must have been much lower than we thought at the time. Hence the actual level of output must have been well above productive capacity, leading to current estimates of a 4-5% positive output gap.

Three points follow from this. First, claims based on these figures that UK fiscal policy was grossly irresponsible before the recession are simply silly. None of the major institutions that analyse the macroeconomy thought in 2007 that the UK was in the middle of a major boom. Even if we assume that what the IMF and OECD now estimate about 2007 is correct, the government – like these organisations – did not have a crystal ball. In 2007 they, and pretty much everyone else, thought the economy was close to trend, and the government based their policy on that judgement. If the government at the time had tried to argue that the economy was in the middle of a major boom, they would have been ridiculed. 

Second, 2007 did not feel like a boom, so maybe it was not. In an overheating economy we normally see shortages pushing up wages and prices, but that was not happening in 2007. To argue that, despite this, 2007 really was a boom, you have to find reasons why it did not show up in inflation. Maybe in time we will, but nothing obvious springs to mind. This is why the UK productivity puzzle is so puzzling – it really does look as if we either have to rewrite history, or productivity just disappeared in the recession. Alternatively, of course, perhaps productive capacity today is really much more (and the output gap much larger) than people currently think, as some have suggested (most recently here).

Third, does this mean looking at cyclically adjusted budget deficits is a bad idea, if the adjustment itself is so uncertain? The answer is clearly no. It makes sense to run surpluses in a boom and deficits in a recession. We do the best we can to estimate when we are in a boom and when we are in a recession. Much of the time it is pretty obvious. It was obvious from inflation data, for example, that periphery Eurozone countries were experiencing boom conditions before the recession, and that therefore they should have been running bigger budget surpluses. Sometimes, particularly in extraordinary times like these, we may get things wrong, but that does not imply that we should give up trying.