The Deficit and Unemployment

Earlier this year, I unveiled my Simple Rule for Government Finances. The equation is simple: Take the unemployment rate and multiply it by -2, then add 10 and that should be the government’s deficit as a percent of GDP.

With today’s new data point on the government’s deficit as percent of GDP we can see that my equation holds up well with one out-of-sample data point. Hooray!

Here’s a chart of the Unemployment Rate (blue line, left scale) along with the Deficit as a Percent of GDP (black, right). I’ve scaled the two axes to follow my rule.

Simply put, my equation says that the budget should be balanced when the economy is at 5% unemployment. For every 1% it moves above that, the deficit increases by 2% of GDP. For every 1% below that, the surplus increases by 2% of GDP.

The relationship has held up fairly well for the last 30 years. It’s interesting to see how government financing is a function of the economy—and of course, the economy is impacted by government finances. Perhaps my equation reflects some sort of equilibrium.

If this relationship is accurate, it suggests that the deficit was too high during the GWB years, but too low during the early Reagan years. Perhaps real rates explain the difference.

Posted by Eddy Elfenbein on November 7th, 2013 at 3:37 pm

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