Structural and cyclical deficit

Structural (blue) and cyclical (green) components are summed to give the headline deficit/surplus (red) for a hypothetical economy

Structural and cyclical deficits are two components of deficit spending. These terms are especially applied to public sector spending which contributes to the budget balance of the overall economy of a country. Deficit spending, or simply deficit, is defined as over-spending: the amount by which spending exceeds revenue over a particular period of time. The total budget deficit, or headline deficit, is equal to the sum of the structural deficit and the cyclical deficit (or surplus/es).

Cyclical deficit

A cyclical (temporary) deficit is a deficit that is related to the business or economic cycle. The business cycle is the period of time it takes for an economy to move from expansion to contraction, until it begins to expand again. This cycle can last anywhere from several months to many years, and does not follow a predictable pattern.

The cyclical deficit is the deficit experienced at the low point of this cycle when there are lower levels of business activity and higher levels of unemployment. This leads to lower government revenues from taxation and higher government expenditure on things like social security, which may cause the economy to go into deficit. While the cyclical component is affected by government decisions, it is mainly influenced by national and international economic conditions which can be significantly beyond government control.

Structural deficit

A structural (permanent) deficit differs from a cyclical deficit in that it exists regardless of the point in the business cycle due to an underlying imbalance in government revenues and expenditures. Thus, even at the high point of the business cycle when revenues are high the country's economy may still be in deficit. The structural component of the budget is a good indication of a government's financial management, as it indicates the underlying balance between long-term government revenues and expenditure, while removing factors that are mainly attributable to the business cycle.

As deficits must be funded by borrowing, a structural deficit is an issue for a government as even at the high points of the business cycle the government may need to continue to borrow and thus continue to accumulate debt. This will lead to continued deterioration of the debt-to-GDP ratio, a basic measure of the health of an economy and an indication of the country's ability to pay off its debts.

Structural deficit issues can only be addressed by explicit and direct government policies, primarily involving reducing government spending or increasing taxation. An alternative in countries which have fiat money is to address high levels of debt and a poor debt-to-GDP ratio by monetising the debt, essentially creating more money to be used to pay off the debt. Monetising the debt can lead to high levels of inflation, but with proper fiscal control this can be minimised or even avoided. Both it and the final option of defaulting on the debt are thought to be poor results for investors. There having been recent incidents involving quantitative easing in the UK, the U.S. and the Eurozone following the 2008 global financial crisis. These are the first instances of either since the dropping of the gold standard.

Structural deficits may be planned, or may be unintentional due to poor economic management or a fundamental lack of economic capacity in a country. In a planned structural deficit, the government may commit to spending money on the future of the country in order to improve the productive potential of the economy, for example investing in infrastructure, education, or transport, with the intention that this investment will yield long-term economic gains. If these investments work out as planned the structural deficit will be dealt with over the long-term due to the returns on investment. However if expenditures continue to exceed revenues, the structural deficit will worsen. A government may also knowingly plan the budget to be in deficit in order to sustain the country's standard of living and continue its obligations to the citizens, although this would generally be an indication of poor economic management. Ongoing planned structural deficits may eventually lead to a crisis of confidence in investors regarding the country's ability to pay the debt, as seen in the financial crises in a number of European countries since the late-2000s, especially the Greek and Spanish financial crises.

Structural and cyclical surplus

Structural and cyclical surpluses are the opposite of the deficits described above.

With a cyclical surplus, at the high point of the business cycle government revenue will be expected to be higher and government expenditure lower, meaning revenue exceeds expenditure and the government experiences a surplus.

Likewise, a structural surplus is when the economy is fundamentally operating at a surplus regardless of its point in the business cycle.

Interplay of structural and cyclical components

The overall government budget balance is determined by the sum of the cyclical deficit or surplus and the structural deficit or surplus (refer to chart). Therefore, for example, a cyclical surplus could mask an underlying structural deficit, as the overall budget may appear to be in surplus if the cyclical surplus is greater than the structural deficit. In this case, as economic conditions deteriorated and the budget went into cyclical deficit, the structural and cyclical deficits would then compound leading to higher deficits and more dire economic conditions.

An example of this occurred in Australia during the later years of the Howard Government. From 2009 Treasury attempted to separate cyclical and structural components of the budget balance, and first started publishing estimates of the structural component. Treasury showed that despite a run of large and often unexpected headline surpluses, the Australian economy was in fact in structural deficit from at least 2006–07, and was deteriorating as far back as 2002–03. At this time they determined that despite a headline surplus of A$17.2 billion in 2006–07, there was an underlying structural deficit of around $3 billion, or 0.3% of GDP. This structural deficit was caused by a mining boom leading to extremely high revenues and large surpluses for several consecutive years, which the Howard Government then used to fuel spending and tax cuts, rather than saving or investing them to cover future cyclical downturns. With the Global Financial Crisis unexpectedly starting in 2007, revenues quickly and significantly declined and the underlying structural deficit was exposed and exacerbated, which then had to be dealt with by later governments. By 2008–09 when the budget had a headline deficit of $32 billion, the structural deficit was out to around $50 billion. In 2013 it was estimated the structural deficit remained at about $40 billion, or 2.5% of GDP.

Criticism

Economist Chris Dillow has questioned the distinction between cyclical and structural deficits, and this has received support from other leading economists. He contends that there are too many variables involved to allow a clear distinction to be made, especially when dealing with current circumstances rather than retrospectively, and suggests that the concept of structural deficits may be used more for political purposes than analytical purposes.

The piece largely centred on the UK Labour government 1997-2010 of which Chris Dillow was a strong supporter and criticism that they ran a large structural deficit. Economic representatives of that government acknowledge that, unbeknownst to them at the time, they were running a structural deficit.

Economist, Professor Bill Mitchell has also questioned the misuse of the term 'structural deficit', particularly in the Australian context.

Martin Wolf, in his book "The Shifts and the Shocks", argues that nobody knows what the 'structural' or cyclically adjusted balance is and that it is least knowable precisely when such knowledge is most essential, namely, when the economy is experiencing a boom. He provides two examples of widely divergent IMF estimates of the average structural fiscal balance of Ireland and Spain, for the period 2000-2007. The estimates were made in 2008 and in 2012 and Wolf stresses that they were post-fact estimates and not predictions.

Specifically, in 2008, the IMF declared that Ireland had run an average structural surplus of 1.3% of GDP, per year, between 2000 and 2007, and Spain an average structural surplus of 0.5% of GDP, per year, over the same period. Then, four years later, the IMF decided that, for this same 8-year period, Ireland's annual average structural balance was four percentage points worse than it had thought in April 2008, estimating that Ireland had been running an average structural fiscal deficit of 2.7% of GDP. For Spain, the 2012 IMF estimate differed by 1.7 percentage points, estimating this time that Spain had been running and average structural fiscal deficit of 1.2% of GDP, in the years 2000-7.