How should Europe measure compliance with its fiscal rules?

The 13 January 2015 European Commission’s communication on “Making the best use of the flexibility within the existing rules of the Stability and Growth Pact” usefully clarifies that EU members struggling with weak cyclical conditions would be allowed to slow down the pace of their fiscal adjustment (European Commission 2015). But the extent to which this clarification is helpful hinges on how the Commission will assess whether cyclical conditions are indeed weak. The approach currently followed is problematic. Let me explain why and how the problem can be fixed.

Assessing cyclical conditions

Assessing whether cyclical conditions are weak requires estimating the output gap and its change over time. The output gap is the difference between actual and potential GDP, i.e. how much the economy would produce in normal demand conditions. If the output gap is negative (GDP is below its potential level) and its size is rising, there is (rising) spare capacity in the economy. In this case, it makes sense to slow down fiscal adjustment because the deficit adjusted for the cycle (the cyclically-adjusted deficit or, if you adjust also for one-off items, the structural deficit) is not as high as the headline deficit (as, for example, revenues are only temporarily weakened by the recession); and because you do not want to make things worse by cutting spending in a recession. So, some key aspects of the Stability and Growth Pact (SGP) fiscal rules have been, appropriately, defined in structural terms. For example the medium-term fiscal objective (MTO), under the so-called preventive arm of the Pact, is defined in structural terms. The speed of adjustment to reach the objective is also defined in structural terms, and the required speed depends on the level of the output gap, which is affected by potential growth estimates. Moreover, compliance with the fiscal adjustment effort required to countries under the corrective arm of the Stability Pact is also defined in structural terms. Finally, compliance with the debt rule depends – in the interim period lasting for some countries through 2015 – on the improvement in the structural balance.

• In sum, the estimate of potential output growth and of structural balances is absolutely critical for the working of Stability and Growth Pact rules, something that is often not well appreciated.

Unfortunately, potential output growth is unobservable and mistakes in estimating potential output levels and growth rates can lead to sizeable errors in evaluating the fiscal stance and in implementing fiscal rules (Tereanu et al. 2014)

The way the Commission currently estimates potential output—following a methodology agreed with member countries—yields potential growth estimates that are very low (Havik et al. 2014). For example, more than one third of Eurozone countries, including Italy and Spain, are estimated to have had negative or zero potential growth in 2014 (and previous years). A negative potential growth means that an economy would shrink even under normal cyclical (demand) conditions, something puzzling even for countries with non-trivial structural problems like Eurozone countries.

Fiscal adjustments and growth

Calibrating fiscal adjustment on negative (or very low) potential growth rates has severe drawbacks for the working of fiscal rules. Intuitively, as soon as you start growing at a decent pace, you need to accelerate fiscal adjustment because you appear to grow ‘fast’. Take, for example, an economy where potential growth is estimated to be a negative half percent. A year in which growth is projected to be barely positive, say half a percent, would be seen as very good (actual growth exceeds potential growth by a whole percentage point); it is easy to compute (using standard elasticities of the fiscal deficit to output gap changes) that the headline deficit would then need to fall by some half percentage point of GDP with respect to the previous year just to keep the estimated structural deficit unchanged, and by as much as one percentage point to attain the structural improvement of half percentage point required by Pact rules for countries with limited output gaps. Is a one percentage point cut in the deficit appropriate for a country that grows by just half percent?

Well, perhaps yes, if potential growth were indeed negative. But where does the Commission get these negative potential growth rates? The Commission’s potential output estimates are based on a ‘production function’, in which potential output depends on an estimate of full employment, the capital stock, and the level of productivity. But, just to quote an example of why this approach is problematic, the capital stock is derived as the sum of past investment, and investment is highly cyclical, responding negatively to weak demand conditions. Thus, the Commission’s potential output estimates reflect in part the aggregate demand cycle (albeit not as much as output itself). And, as demand was very weak in the last few years (and continues to be weak as evidenced by the large undershooting of inflation with respect to its target), so are the estimates of potential growth.

All this suggests that the Commission’s approach to estimate potential growth should be revisited. But leaving aside statistical modelling questions (I am sure we could discuss endlessly about those), there is a more fundamental problem. The Commission itself, together with the above mentioned estimates of potential output, projects how potential output will evolve over the medium term, in this way distinguishing between short-term and medium-term potential output growth. Using the estimated medium-term potential output growth to assess compliance with the fiscal rules would be conceptually more appropriate, as what we are trying to capture are medium-term fiscal trends, and would go a long way in avoiding unreasonably low (and cyclical) potential growth rates. Indeed, the medium-term potential growth rates estimated by the Commission (for example, those projected for 2019-2020 and beyond) are positive for all of the countries that in 2014 were estimated to have negative or zero potential growth, including Italy and Spain (whose medium-term potential growth rates are estimated to exceed 1.25%).

Conclusion

In sum, the increased focus on structural rather than headline deficits to assess compliance with many Stability and Growth Pact rules is welcome but does require using potential growth estimates that are not too low and cyclical. Otherwise, we would end up treating a year of modest expected growth like 2015 as a year of economic boom that requires faster than normal fiscal adjustments. The issue of the methodology used to compute structural fiscal balances may sound one of limited consequence but we know well where the devil rests.

References:

European Commission (2015), “Making the best use of the flexibility within the existing rules of the Stability and Growth pact”, Communication from the Commission to the European Parliament, The Council, the European Central Bank, The Economic and Social Committee, the Committee of the regions and the European Investment Bank, Strasbourg, 13 January, COM(2015) 12 final provisional.

Tereanu E, A Tuladhar, and A Simone (2014), “Structural Balance Targeting and Output Gap Uncertainty”, IMF Working Paper, WP/14/107.

Havik K, K Mc Morrow, F Orlandi, C Planas, R Raciborski, W Roeger, A Rossi, A Thum-Thysen, V Vandermeulen (2014), “The Production Function Methodology for Calculating Potential Growth Rates & Output Gaps”,  European Commision, Economic papers 535, November.

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Carlo Cottarelli, a citizen of Italy, has been Director of the Fiscal Affairs Department since November 2008.

Image: A huge euro logo is pictured next to the headquarters of the European Central Bank. REUTERS/Ralph Orlowski.