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Economic SYNOPSES short essays and reports on the economic issues of the day 2003 ■ Number 26 Global Factors in Budget Deficits Christopher J. Neely iscussions about fiscal deficits—government outlays less rity expenditures. Indeed, the U.S. deficit in 2002 (3.4 percent of tax receipts as a percentage of gross domestic product GDP) was mostly structural (2.9 percent), not cyclical. (GDP)—often overlook the importance of global factors The international correlation in structural deficits illustrates in common movements across countries. The left panel of the that the business cycle is not the only global influence on fiscal figure, for example, shows that deficits in Canada, France, deficits. For example, the “peace dividend,” the cuts in defense Germany, the United Kingdom, and the United States declined spending after the fall of the Soviet Union, accounted for some from the mid- to the late-1980s, increased with the global recesof the international fall in structural deficits in the 1990s. Similarly, sion of 1990, and then improved again from about 1992 through the extraordinary international bull market in equities in the late 2000. Recently, however, deficits have increased; in Germany and 1990s—which was only weakly related to real economic activity— France, they are larger than the European Monetary Union limit probably reduced deficits by increasing tax revenues on capital of 3 percent of GDP. gains. The decline in equity prices since 2000 has been associated Why do national fiscal deficits tend to move together? One with a falloff in tax revenues on capital gains. Finally, the Maastricht reason is that deficits react to common business cycle shocks. Treaty, which established the European Monetary Union on That is, global economic activity is subject to common shocks to January 1, 1999, limits deficits to 3 percent of GDP. This treaty technology, demographics, commodity prices, and political uncerobligation forced cuts in French and German deficits in the 1990s. tainty. Further, international trade links countries’ economies. In evaluating deficits, one should carefully consider the source. Over a business cycle, government outlays fall and tax receipts Cyclical deficits, which often have a strong global component, rise with economic activity. Such changes are called automatic do not threaten long-term fiscal solvency because they will be stabilizers; they make deficits vary with the business cycle. Governreversed over time. However, large structural deficits—those ments often raise discretionary spending or cut taxes during greater than the country’s average output growth rate—cannot periods of low output, further amplifying the connection of be maintained forever and might require adjustments to tax and deficits to economic activity. Because countries tend to share spending policies. ■ business cycles, which are correlated with deficits, deficits tend to be correlated internationally. The portion of a deficit that is due to the level of economic activity Fiscal deﬁcits Structural deﬁcits % of GDP Canada % of GDP Canada is called the cyclical deficit, while the 10 10 France France structural deficit is the shortfall that Germany Germany 8 8 UK would exist even if the level of ecoUK US 6 US nomic output were at its potential. 6 The right panel of the figure shows 4 4 estimates of structural deficits. 2 Structural deficits can result 2 0 from changes in tax and spending preferences or external events. For 0 –2 example, the U.S. deficit rose in 1992 –4 –2 when savings and loan depositors 1980 1985 1990 1995 2000 1980 1985 1990 1995 2000 were bailed out. And the terrorist SOURCE: OECD Economic Outlook. attacks of September 11, 2001, and NOTE: The panels show ﬁscal deﬁcits and structural deﬁcits as a percentage of GDP. Deﬁcits are measured as wars in Afghanistan and Iraq surely a percentage of GDP because larger, richer economies can more easily aﬀord to run higher deﬁcits than can inflated the U.S. deficit through poorer countries. Figures for 2003 and 2004 are projections. higher defense and homeland secu- D Views expressed do not necessarily reflect official positions of the Federal Reserve System. research.stlouisfed.org