Structural Balance

The structural balance is a government budget adjusted to remove temporary effects of the business cycle. It reveals what the deficit would be if the economy were operating at its normal, or potential, level of output — stripping away the distortions of recession or boom.

How the structural balance is calculated

The structural balance starts with the actual budget deficit and adjusts it for the distance between actual and potential economic output. If the economy is in recession and actual GDP is 3% below its potential (trend) level:

• Actual tax revenues are depressed because incomes and profits are lower.
• Automatic spending programs like unemployment insurance are inflated.
• The actual deficit appears worse than it really is.

The structural balance adjusts these revenues and spending back to what they would be if the economy were at potential output. This reveals the underlying fiscal stance: whether the government is, in fact, running loose or tight policy, or whether it simply looks that way because of temporary conditions.

Why structural balance matters

Policymakers care about the structural balance because it separates policy choices from economic luck. During a deep recession, the actual deficit surges, but this may reflect temporary loss of revenue and automatic spending increases, not permanent loosening of policy. Conversely, a government may appear fiscally responsible during a boom when the actual deficit shrinks, but if that shrinkage is entirely cyclical, the underlying fiscal stance may be unsustainable.

By focusing on the structural balance, policymakers and analysts ask: if we removed the business-cycle noise, would the government be on a sustainable fiscal path? Are tax and spending policies, in themselves, excessive or inadequate?

The problem of measuring potential output

The structural balance is only as good as the estimate of potential output. Potential GDP is not directly observable — it is an estimate of what the economy could produce if operating at normal utilization. Different methods yield different estimates. After the 2008 financial crisis, estimates of US potential output were revised down repeatedly, suggesting that the economy had suffered permanent damage. This changed assessments of the structural deficit: if potential output is lower than expected, the structural deficit is larger.

Estimating potential output requires assumptions about the long-run trend growth rate, the natural rate of unemployment, and the trend-level productivity. Get these wrong, and the structural balance calculation is misleading.

Structural balance in practice

The European Union and the International Monetary Fund use structural balance measures to assess fiscal policy. European fiscal rules focus on the structural deficit, not the actual deficit, to allow more discretionary spending and tax cuts during downturns (so the actual deficit can be larger) while requiring more austerity in booms (to keep the structural deficit low).

The logic is sound: encourage counter-cyclical policy. In practice, these rules are complex and often violated. Disputes over potential output estimates can delay consensus on whether a government is violating the rules.

Relationship to other measures

The cyclically adjusted deficit is closely related but slightly different. The structural balance typically adjusts only for the business cycle (the gap between actual and potential output). The cyclically adjusted deficit may also adjust for other temporary factors (unusual revenue or spending swings) or for policy changes. The two terms are often used interchangeably, but structural balance is the more precise term for business-cycle adjustment alone.

See also