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.