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Sand Fiscal Foundations

Simon Wren-Lewis has an interesting piece on structural deficits. He has issues with Pisani-Ferry’s plea for more stable  structural deficit targets for EU countries. While Pisani-Ferry has a point in invoking more certainty for EU government action, Wren-Lewis argues, rightly so, that stable targets risk creating straitjackets for countries, and that the problem is mostly in the excessively short time horizon of structural deficit targets.

The fact that both Pisani and Wren-Lewis have a point highlights what is in my opinion a structural flaw of EU fiscal governance, namely its reliance on the slippery concept of structural government deficit.

To explain this simply, the idea underlying structural deficit targets is that  not all deficit were created equal. if the government runs a deficit because of adverse cyclical conditions (low growth yields lower tax revenues and larger welfare payements), this deficit is “healthy” because it supports economic activity, and bound to disappear when the economy recovers. As such, governments should not be required to target cyclical deficit, but only  the structural (or cyclically adjusted) deficit, which is precisely the deficit “cleaned” of its cyclical component.

The EU fiscal rule, the Stability Pact and its hardened Fiscal Compact extension, recognizes this distinction, and imposes that governments balance their budget over the cycle, which is yet another definition of structural deficit. This may seem a sensible approach, recognizing, as I just said, that not all deficits were created equal. But in fact sensible it is not.

The problem lies precisely in the word “cleaned” I used above . How do we clean headline deficit from its cyclical component, to compute the structural deficit that should be targeted by governments? This is how we should do it: We compute “potential output”, i.e. the capacity of production of the economy. From that we can obtain the output gap, i.e. the distance of actual output from its potential level; finally, by applying an estimate of how the deficit responds to the output gap, we can clean headline deficit from its cyclical component. Simple, right? Yes, in theory. In practice, we have no way to do it in a sufficiently precise way.

Just consider what the Commission itself states in the page dedicated to its own methodology for measuring potential output. (Their most recent methodological paper can be found here).

Any meaningful analysis of cyclical developments, of medium term growth prospects or of the stance of fiscal and monetary policies are all predicated on either an implicit or explicit assumption concerning the rate of potential output growth. Given the importance of the concept, the measurement of potential output is the subject of contentious and sustained research interest.

All the available methods have “pros” and “cons” and none can unequivocally be declared better than the alternatives in all cases. Thus, what matters is to have a method adapted to the problem under analysis, with well defined limits and, in international comparisons, one that deals identically with all countries. (emphasis is mine)

There is nothing wrong with recognizing that potential output estimates are “contentious”. Contrary to what some Talebans persist to argue, economics is a social science, subject to all the uncertainties, mismeasurements, and ambiguities that are inherently linked to human and social interactions.

Where we have a problem is in using a contentious concept as the foundation for rules in which a zeropointsomething deviation from the target may lead to sanctions and public disapproval by the EU community, with all the potential financial market disruptions associated with it.

This makes the rule non credible, because the contentious estimate may be questioned. More importantly, it leads to what Wren-Lewis fears: countries imposing harsh sacrifices to their people that may turn out to be unwarranted when the estimate is revised.

I am not clear about what fiscal rule we should have in the EU. I actually am not even convinced that we really would need one. What is certain is that two necessary conditions for any rule to be effective, credible, and reasonable are that it is not short -termist (I rejoin Wren-Lewis), and that it is based on indicators that are quantitatively as precise as possible.

The current rule fails on both ground (and don’t get me started on how crazily complicated and arbitrary it grew over time). EU fiscal governance remains founded on sand. And of course, a serious debate on its reform is nowhere to be seen in European policy circles.

  1. cig
    April 12, 2015 at 12:11 pm

    Good points, but then no rules at all would be worse, absent a central fiscal authority. Rules based on mistaken certitudes would also be worse. Is then, the status quo, fuzzy rules with self doubt, that far from the best we could get given current circumstances?

  2. Dr. John T. Smith
    April 12, 2015 at 2:55 pm

    Hello Francesco, As someone with some access to inside information, I can say that while many are increasingly prepared to show open criticism about the EU methodology for computing potential output, the Commission seems to be digging in and to cling ever more tightly to its method, which it claims is “State of the Art”, at the very frontier of economics in methods and theory… Realism is not given much consideration when the Commission states that a member state’s NAIRU (NAWRU) can be around 20%… Its a bit frightening to see…

    • Marco Cattaneo
      April 13, 2015 at 8:05 pm

      Good comment, which also is an excellent reply to cig. NAIRU / NAWRU around 20%: plainly CRAZY.

  3. Patrick VB
    April 13, 2015 at 12:00 pm

    Francesco,
    In your above post, you refer to the 2006 paper on the Commission’s Production Function methodology; there is a much more recent paper on this (http://ec.europa.eu/economy_finance/publications/economic_paper/2014/ecp535_en.htm); more recent, and in which we can perceive that the methodology is becoming ever more complicated…
    Regards,
    Patrick

  4. Max
    April 14, 2015 at 5:03 pm

    The idea of an externally imposed fiscal rule is strange. There’s no reason why each government should not formulate its own rules, assuming that each government is solely responsible for its debt.

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