Monday, May 22, 2006

Budget Deficit Shrinks!

Want to reduce the U.S. budget deficit by \$175? It is easy. Just correct it for inflation.

Several commentators on a previous post expressed shock and dismay that the \$600 billion figure that Senator Lieberman and President Bush have cited for the worsening in Social Security's finances is not corrected for inflation. That is, part of the increase in the present value of the shortfall is explained by a higher overall price level in the economy, suggesting it does not reflect a real increase in the problem. A fair point.

The exact same point can be made about the budget deficit as normally reported. Here is an excerpt from the best-selling intermediate macro textbook that explains how to make the inflation correction.

Measurement Problem 1: Inflation

The least controversial of the measurement issues is the correction for inflation. Almost all economists agree that the government's indebtedness should be measured in real terms, not in nominal terms. The measured deficit should equal the change in the government's real debt, not the change in its nominal debt.

The budget deficit as commonly measured, however, does not correct for inflation. To see how large an error this induces, consider the following example. Suppose that the real government debt is not changing; in other words, in real terms, the budget is balanced. In this case, the nominal debt must be rising at the rate of inflation. That is,

ΔD/D = π,

where π is the inflation rate and D is the stock of government debt. This implies

ΔD = πD.

The government would look at the change in the nominal debt ΔD and would report a budget deficit of πD. Hence, most economists believe that the reported budget deficit is overstated by the amount πD.

We can make the same argument in another way. The deficit is government expenditure minus government revenue. Part of expenditure is the interest paid on the government debt. Expenditure should include only the real interest paid on the debt rD, not the nominal interest paid iD. Because the difference between the nominal interest rate i and the real interest rate r is the inflation rate π, the budget deficit is overstated by πD.

This correction for inflation can be large, especially when inflation is high, and it can often change our evaluation of fiscal policy. For example, in 1979, the federal government reported a budget deficit of \$28 billion. Inflation was 8.6 percent, and the government debt held at the beginning of the year by the public (excluding the Federal Reserve) was \$495 billion. The deficit was therefore overstated by

πD = 0.086 x \$495 billion = \$43 billion.

Corrected for inflation, the reported budget deficit of \$28 billion turns into a budget surplus of \$15 billion! In other words, even though nominal government debt was rising, real government debt was falling.

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How much does this correction matter now? CPI inflation over the past year has been 3.5 percent. Government debt held by the public is about \$5 trillion. This means the U.S. budget deficit is overstated by about \$175 billion dollars.