The output gap is the trojan horse of the fiscal compact

by florincitu

Romania, via its president, has adhered wholeheartedly to the euro area fiscal compact. To sell the story the Romanian officials are presenting this version of the rules based fiscal policy as a panacea to the chronic fiscal policy problems of this country. And to make the story stick “friendly” economists are presenting only the benefits of such a policy. Thus, it gives me great pleasure to show you the dangers of such a policy especially for the private sector.

The main point of this new fiscal rule is that via a structural deficit governments in the euro area and the few governments outside this group but oblivious to own country particularities will achieve fiscal surplus.

Theoretically, the structural balance methodology isolates the impact of the business cycle on public finances. For every annual budget the level of fiscal expenditure is consistent with revenues collected as if the economy were fully using the productive capacity (at the potential GDP). Therefore, when the economy is overheated, the government naturally collects larger than “normal” tax revenue, but it does not increase expenditure (theoretically of course), thus accumulating savings; and in the recession, the government uses those savings to cover depressed tax revenue associated to the slower economic activity, thus maintaining the trend of expenditure. I am not certain if the rule adopted for the euro area will be exactly like this one.

However, the biggest risk lies within this rule. It refers to the use of potential GDP. Potential GDP is not measurable and it needs to be estimated. There are few methods that do this but the fact is that you will never be able to know what is the actual potential GDP.

The dangers of using potential GDP for policy making are not new. The economic literature is full of papers showing that using output gap for economic policy can lead to grave errors. Granted most of the research focuses on monetary policy where even today the output gap plays an important role in the process of inflation forecasting. For example imagine a monetary policy responds by increasing interest rates in response to a positive output gap (i.e. real GDP is above potential GDP). As the result the economy slows down losing jobs, lowering profits and increasing social transfers. What if that estimate was wrong and the economy was not above potential GDP? We will never know for sure.

Here is another example. Assume that estimates of potential GDP done by public institutions (and thus potentially manipulated) would show the economy growing below potential. Then monetary policy will respond by lowering interest rates. But what if the estimate is manipulated to make monetary policy loose? What if we are in an election year? This can definitely happen and to some extent I think it does especially in emerging markets where transparency of public institutions is non-existent.

The same can happen in the case of fiscal policy. Especially since estimates of the potential GDP are done by public institutions and not independent ones. To recap the structural budget balance represents what government revenues and expenditures would be if output was at its potential level. In contrast, the actual budget balance also reflects the cyclical effects of economic activity and therefore fluctuates around the structural budget balance. Structural budget balances are therefore estimated by taking actual government revenues and expenditures and breaking them into estimated cyclical and structural components.

Now, the relationship between output gap and structural balance is the following: a positive output gap will result in higher cyclical surplus and an effective budget deficit lower than the structural one. Therefore, is in the interest of the policy maker to manipulate the potential GDP to allow for a bigger positive output gap which in turn will result in a smaller overall deficit. The opposite is true for negative output gap.

If euro area is serious about fighting fiscal excess why not set the target a surplus and not a deficit. Only then all this effort will be more credible.

Finally, to illustrate the problems with estimating the potential GDP here is an example from the NZ Treasury. They use three statistical filtering technies and a method using a production function. All of them are different. Then the question is which one is close to the reality?

Here are few good papers about he problems of the output gap: