The dangerous side of the structural balance target

Last week I proposed a total change for the Romanian fiscal policy regime. I proposed to move from a discretionary fiscal policy to a rules based fiscal policy in Romania. There, I presented few targets for this new policy rule and one of them was a structural deficit of zero.

After the EU summit last week Romanian politics and media have been throwing around the new “0.5.% structural deficit” target proposed by the EU leaders as a panacea. However, the level of the discussions about the structural balance shows that the concept is not understood. Also, the discussion is not presenting the potential for manipulation of such a policy if the current fiscal framework remains intact.

First of all I have to apologize for not taking my original analysis of this subject further. I only presented to you the targets but not the framework surrounding those targets. Mainly, I did not say why there is a need to have a zero structural deficit.

The first essence of the structural balance was somewhat captured by the recent discussions in the media: the automatic stabilizers. Automatic stabilizers are elements of the budget that tend to increase revenues during an expansion (such as taxes on incomes and profits) and increase expenditures during a recession (such as spending for unemployment compensation and antipoverty programs). When automatic stabilizers operate, the budget automatically swings toward surplus during an expansion and toward deficit during a recession. The automatic move toward surplus helps prevent overheating when the business cycle approaches its peak. At the other end of the business cycle, the automatic stabilizers move toward deficit and help to moderate the depth of the downturn.

As it is right now in Romania automatic stabilizers are turned off. During this crisis, as unemployment benefits and other income-support measures increased, other discretionary spending had to be cut and taxes raised, to prevent a deficit from developing. Those changes made the recession worse than it otherwise would have been. Similarly, we know that the annual balance rule provided no budget discipline during the expansion period up to 2008. Instead of allowing a surplus to develop as the cycle approached its peak, increasing revenues were used to finance expenditure increases, leading the expansion into overheating. That, my friends, was a procyclical fiscal policy.

Turning back to the structural deficit, I proposed a zero target for a reason. The structural budget balance is the surplus or deficit excluding automatic stabilizers. In other words it shows the difference between the expenditures that would be made and the revenues that would be collected if the economy were operating at potential GDP.

The need to estimate a potential GDP is the reason why we need to be very careful about the framework for this fiscal policy regime. In this framework we need to have a good unbiased estimate of the output gap every year. For those not familiar with the output gap it represents the difference between the current level of GDP and its potential level. But the potential GDP will always be an estimation and thus open to manipulation in the wrong hands.

If Romania is serious about implementing a rules based fiscal policy it needs to take the estimation of potential GDP from the hand of the government staff. I have already shown that there is upward bias in ALL of the official estimates for the economy including the ones from the IMF. Also, I hope we do not give the job to the Fiscal Council which is not an independent institution considering its board and their other jobs.

In conclusion, to make this work Romania needs a workable target (structural balance) and most importantly an independent institution to measure it and thus help implement it. Oh, one more thing we need is political will, but there is an inflation of it right now all over the media thus it should not be a problem.

6 thoughts on “The dangerous side of the structural balance target

  1. Politicians like to turn simple things into easy to do things. Here’s my take on this:

    There’s a principle called: unified leadership. If you lead a group, there should be only 1 person that makes the final decision. Otherwise, the group will tend to move randomly in a bunch of directions without a real target.

    To hit a target, you need to push towards it relentlessly. And if the leadership is divided, you will just expand your reach without necessary making any progress towards your long term objectives. You will get bigger, smarter, fatter without making any real progress

    Let’s apply the same principle to running a state:

    1. Clearly defined long term objectives.
    Set a targets and deadlines + penalties and rewards. If a politician doesn’t do its job & what he has promised, he will be excluded forever from the political arena. Everyone that didn’t deliver what they promised in the last 6 months, will have to find something else to do. They are not needed anymore.

    2. Only 1 person should decided what are exactly the long term objectives.
    Only 1 person should make the final decision.

    3. Every person that works in the public sector should further the achievement of these long term goals.
    If they don’t, they should do something else.

    4. The goals should not conflict with each other.
    It doesn’t make sense to want to grow your GDP while you also pay your debt. You should grow the prosperity of the people, but not necessary the GDP of the country. And you should clearly define what it means for a person to increase their living standards. If you can’t definite, you shouldn’t have a goal for it because you don’t understand it. Set goals that you understand.
    ****
    Example:
    Let’s say that the goal is to pay off the debt completely in 10 years.

    On a big screen inside the state’s institutions, there’s should be written: “The goal is 5% completed. We still have to pay 23.5 billions dollars. What can you do today?”

    All the objectives should be known by anyone in the country and inside the government.

    If you want to pay off your debt it means that you shouldn’t borrow any money regardless of the circumstances. And you should set targets of budget surpluses instead of budget deficits. The entire paradigm will have to switch because you have a clear target that needs to be accomplished. Nothing else matters.

    The state would need to have both long term and short term targets.

  2. independent institution to measure it

    Do you believe that such a thing even exists? An institution or people able to reliably forecast the potential output in the coming year, with that precision?

    No wonder this “rule” has more chances to get passed into EU members’ Constitutions, as it’s so much more “flexible” (a se citi, “se poate face din pix”) than the 3% govt deficit/GDP from the Maastricht Treaty.

      1. Care to link to, or to name them? Just curious about how the track record for such an institution might look like.

        I mean, the ability to forecast something that usually ends up being revised, even 1-2 years after, with sometimes double that 0.5% figure, must be really something.

      2. It is impossible to get an exact forecast of any variable irrespective of the model. But this not the role of an independent institution in this fiscal regime. Its role is to eliminate the political bias from the estimates. The problem with estimating a potential GDP is that it lacks any theoretical support and only relies on an econometric techinique. Therefore, much easier to manipulate than of one would work with real growth rate estimate.

        Also, the point of havin a zero target for the structural deficit is paramount here as even the 0.5% can be manipulated by politicians into 2% just by playing with the potential GDP.

        It is not a perfect solution but it is net superior to what we have now in Romania.

        By the way I only suport this for Romania not within a new treaty to be signed with EC. That will be a nightmare to implement and monitor.

        Sent from my iPhone

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