A couple of months ago former Federal Reserve Chairman Alan Greenspan ruffled feathers by criticizing the fiscal record of the Bush Administration.  Dick Cheney himself responded in a Wall Street Journal op ed.  Yet largely lost in the argument was Greenspan’s suggestion that we switch from a cash flow to an accrual method when measuring the federal budget deficit.  (See this interview , about 2/3 of the way down.)  In this post I explain the difference.

Currently, the reported federal budget deficit is the amount that current expenditures exceed revenues.  For example, if the government takes in $2 trillion in taxes and fees, and spends a total of $2.2 trillion on the military, food stamps, and so on, then the official budget deficit for that fiscal year is $200 billion.

This approach seems straightforward enough, and it generally corresponds with the outstanding issues of public debt.  In the example above, the government could cover the shortfall by issuing a net additional $200 billion in Treasury bonds; after all, the money has to come from somewhere.

However, an interesting anomaly occurs when sometimes the official public debt goes up, even when the government is retiring (on net) its outstanding bonds.  For example, even though there were several years during the Clinton Administration when the government ran an official budget surplus, nonetheless the official federal debt went up every year under Clinton-Gore.  (See the Census Bureau’s own Excel file.)

This discrepancy goes to the heart of Greenspan’s suggestion to use an accrual method.  The gross federal debt includes all future government obligations, not just the cash flows due to bondholders.  To see the distinction, consider the following exaggerated example:  Suppose the government said, “Anyone who is 45 years or younger, and who contributes $5,000 extra in income taxes this year, will get double his or her normal Social Security benefits upon retirement.”

What would the effect be?  Presumably many millions of Americans would accept this offer.  Consequently the current budget deficit (measured in terms of cash flows) would be much smaller, due to the many millions of extra $5,000 one-time payments this year.  Yet the government’s true fiscal position would be much worse because of this deal, since the windfall tax revenues in the present year wouldn’t come close to covering the new liabilities owed to future retirees.  (In other words, for most people the present value of a doubling of Social Security benefits would far exceed a one-time installment of $5,000 today.  This would be particularly true for high income earners already near retirement age.)

So what Greenspan suggests is that we switch to an accrual method of measuring the federal budget deficit, since it more accurately reflects the true long-term benefits and costs of policies.