Tuesday, August 14, 2012

Yet another reason why nominal income matters

Nominal output gap and federal deficit. Source: St Louis Federal Reserve.

The blue line is the nominal output gap.  The orange line is the federal deficit.

Before 2008, you can see the effect of various structural policies on the deficit.  We start with Reagan's tax deficits, then Bush and Clinton raises taxes and the deficit tumbles, then W. Bush cuts taxes and the deficit rises.  All through this, the actual deficit tracks the output gap.

So what happens in 2008, when the Fed blows a GIANT HOLE in nominal income?  Exactly what happens every time nominal income falls below trend: it blows a GIANT HOLE in the federal budget, too.  The structural deficit from Obama's tax cuts is tiny compared to the cyclical deficit from the GIANT HOLE in nominal income.

Taxes are nominal.  Spending is nominal.  Debt is nominal.  Real quantities we construct are useful for prying apart the economy and studying its wriggling guts, but their purpose is just to better help us understand a nominal beast.

There's one thing in the economy that controls nominal incomes, and it's responsible for three quarters of this budget deficit.

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