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Wednesday, February 17, 2010

The Economics of the Federal Budget Deficit

Brian W. Cashell
Specialist in Macroeconomic Policy

The Congressional Budget Office (CBO) estimates that the federal budget deficit for FY2009 was $1,414 billion, triple the $459 billion deficit recorded in FY2008. The CBO expects the deficit for FY2010 to be $1,349 billion. The estimate for 2010 is based on current law. The budget deficit in FY2009 was, in dollar terms, unprecedented. Compared to the overall economy, the $1.4 trillion budget deficit equaled 9.9% of gross domestic product (GDP). In 1943, the budget deficit reached 30.3% of GDP. Since 1946 and before now, the largest the budget deficit had been, relative to the overall economy, was 6% of GDP in 1983. 

Over fairly short periods of time, say three or four years, fiscal policy can affect the rate of economic growth by adding to, or subtracting from, aggregate demand. For a time, the effect on the economy may even be larger than the initial change in the budget. These effects, however, tend eventually to diminish because of either higher interest rates or rising prices. There are varying estimates of the total effect on the economy of a change in fiscal policy, but most of them suggest that it reaches a peak somewhere between one and one-and-a-half times the size of the change in the budget. Most macroeconomists believe that effect is realized within one or two years of the initial change in policy. 

One measure economists use to assess fiscal policy is the structural, or standardized-employment, budget. This measure estimates, at a given time, what outlays, receipts, and the surplus or deficit would be if the economy were at full employment. Although the actual budget was in surplus beginning in 1998, the standardized measure first registered a balanced budget in 1999. Between 1992 and 2000, the actual budget surplus increased from -4.5% (a deficit of 4.5%) to 2.5% of gross domestic product (GDP), a shift of 7.0 percentage points. During the same period, the standardized measure rose from -3.3% to 1.1% of GDP. That suggests that a little more than half of the shift was the result of changes in policy, and a little less than half was attributable to the economic expansion. Between 2000 and 2007, the actual surplus fell from 2.5% to -1.2% of GDP, whereas the standardized measure fell from 0.9% to -1.6% of GDP. That the two measures were so close in 2007 suggests that the economy was then near full employment. That the standardized measure fell between 2000 and 2007 indicates an expansionary fiscal policy over the period. Between 2007 and 2009, the standardized budget deficit increased from 1.2% to 7.3% of GDP, indicating a substantially expansionary fiscal policy. 

In the long run, economic growth is determined primarily by three factors: growth in the labor force, the rate of technological advance, and the amount of capital available to the workforce. Of the three, the last one may be the most susceptible to the influence of policymakers. The larger the capital stock, the more productive the labor force tends to be. Although it is possible for fiscal policy to have an effect on the rate of technological progress in the way public money is spent, many believe that it has a larger effect on growth through its influence on the size of the domestic stock of capital and the amount of capital available for each worker in the labor force.

Date of Report: February 2, 2010
Number of Pages: 14
Order Number: RL31235
Price: $29.95

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