9 Cyclical feedbacks on the primary deficit

Finally, let us look at another layer of complexity in the dynamics of government debt and fiscal policy. This involves the macroeconomic feedbacks that a change in the level of economic activity, i.e. real GDP, will have on the government budget deficit.

In the previous sections we have assumed that the change in the primary deficit is entirely determined by government discretionary spending. We can now add a cyclical component to this change to make the picture a little more realistic and to highlight a particular policy problem related to the economically important but methodologically difficult estimation of the cyclical adjustment of the government primary balance.

The cyclical impact on the primary balance is driven by the so-called automatic stabilisers. These are government revenue and expenditure components that automatically react counter-cyclically to the business cycle. On the revenue side, specific tax revenues, which fluctuate in proportion to total income, fall in a downturn. This has a negative effect on the governments revenues and thus increases the primary deficit. On the expenditure side, unemployment benefits, for example, rise in a downturn, which increases primary expenditure and thus also has an increasing effect on the primary deficit. Conversely, in an upswing, tax revenues increase and expenditure on unemployment benefits decreases, which now has a negative impact on the primary deficit.

These components are called automatic stabilisers because, while they have a pro-cyclical effect on the government’s primary deficit, they also have a counter-cyclical effect on aggregate demand and economic activity. Automatic stabilisers, protect the economy to some extent from aggregate demand shocks, even if the government’s fiscal stance does not change. In a recession, for example, automatic stabilisers can stimulate the economy by reducing the tax burden and raising spending on social security (e.g. unemployment benefits). The automatic stabilisers thus automatically dampen (stabilise) macroeconomic upswings and downswings.

In order to define the cyclical feedback of changes in economic activity on the primary deficit, we must first determine the position of the economy in the business cycle (upswing or downswing). The cyclical position is usually determined using what is known as the concept of potential GDP. This measure is intended to indicate the level of GDP at which the economy is in a “neutral” position in the business cycle, meaning that there is neither an upswing nor a downswing.

Assuming we would know the actual value of potential output, we could use the difference between the value of real GDP and the value of potential output – the so-called output gap – to derive the effect of the automatic stabilizers on the primary deficit. We could then split the primary deficit in a cyclical and a non-cyclical component. The non-cyclical component would then indicate the fiscal stance of the government, whether it pursues an expansionary or a contractionary fiscal policy. However, the practical problem is that we cannot know the actual value of potential GDP.

While the concept of potential GDP is theoretically intuitive to macroeconomists, as it has its counterpart in standard theoretical models of macroeconomics,15 it remains a fundamentally unobservable variable. Therefore, statistical techniques are used to estimate it. However, the accuracy and reliability of these techniques is a matter of strong controversy. One main problem is that these techniques make systematic errors in estimating potential output. This is particularly problematic when such measures of potential output are used for actual policy decisions, for example with regard to the fiscal room for manoeuvre of governments.

In the app below, you can simply define a “true” value of potential GDP and its growth rate. This then used to calculate the “true” output gap, from which the effect of the automatic stabilisers on the primary deficit and the cyclical and non-cyclical component of the primary deficit are derived. As before, you can specify a simple path for the development of the primary deficit, however, this time, it will only affect the non-cyclical component of the primary deficit. You can again set shocks and activate macroeconomic feedbacks of fiscal policy. Finally, in this app you can also specify an “estimated” value of potential GDP, which differs from your “true” potential GDP. The app shows, how a wrong “estimate” of GDP translates into a wrong assessment of the non-cyclical component of the primary deficit. Within the simple simulation, this is of course without consequence. But in the real world, it matters quite a lot for fiscal policy, what policymakers believe about the value of potential GDP and the position of the economy in the business cycle.

Potential GDP and cyclical components of the primary deficit: In this app, we add a distinction between a cyclical and a non-cyclical component of the primary deficit. The cyclical component is derived from the difference between real GDP and potential real GDP, which is a new variable for you to manipulate in the simulation. To illustrate the problem of not knowing the true value of potential GDP, we also introduce an “estimated” potential GDP, which you can set. The app illustrates, how a wrong estimate of potential GDP leads to a wrong estimate of the non-cyclical component of the primary balance.

Important assumptions and limitations:

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