Can the Euro's Fiscal Compact Cut Deficit Bias?

Europe’s fiscal compact went into effect January 1, as a result of its ratification December 21 by the 12th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement. The compact (technically called the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) requires member countries to introduce laws limiting their structural government budget deficits to less than ½ % of GDP. A limit on the “structural deficit” means that a country can run a deficit above the limit to the extent — and only to the extent — that the gap is cyclical, i.e., that its economy is operating below potential due to temporary negative shocks. In other words, the target is cyclically adjusted. The budget balance rule must be adopted in each country, preferably in their national constitutions, by the end of 2013.

Will the new approach help? The aim is to fix Europe’s long-term fiscal problem, which since the date of the euro’s inception has been evident in the failure of the Stability and Growth Pact (SGP), the crisis in Greece and other periphery countries that surfaced in 2010, and the various ways in which these countries were subsequently bailed out.

There is no reason to doubt that the eurozone countries will follow through to the extent of adopting the national rules by the end of the year. ["The granting of new financial assistance under the European Stability Mechanism is conditional on ratification of the fiscal compact and transposition of the balanced budget rule into national legislation in due time."] But after that the fiscal compact will probably founder on precisely the same shoals as the SGP.

Since the inception of the euro, its members have made official fiscal forecasts that are systematically biased in the optimistic direction. Other countries do this too, but the bias among eurozone countries is, if anything, even worse than that elsewhere. During a period of economic expansion, such as 2002-07, governments are tempted to forecast that the boom will continue indefinitely. Forecasts for tax revenue and budget surpluses are correspondingly optimistic and so hide the need for adjustment of fiscal policies. During a period of recession, such as 2008-2012, governments are tempted to forecast that their economies and budgets will soon rebound. Since forecasting is subject to so much genuine uncertainty, nobody can prove that the forecasts are biased when they are made.

Fiscal rules such as the SGP ceilings won’t constrain budget deficits, if forecasts are biased. The reason is that governments can in any given year forecast that their growth rates, tax revenues, and budget balances will improve in the subsequent years, and then next year say that the shortfalls were unexpected. Indeed, it turns out that the eurozone bias in official forecasts during 1999-2011 can be neatly characterized as responding to the SGP’s 3% limit on budget deficits by offering over-optimistic forecasts each time governments exceed the limit. In other words, they adjust their forecasts rather than their policies. (The results described here come from a new paper, coauthored with Jesse Schreger: “Over-optimistic Official Forecasts and Fiscal Rules in the Eurozone,” forthcoming 2013 in the Review of World Economy, vol.149, no.2, from Germany’s Kiel Institute.)

Phrasing the budget rules in cyclical terms, while highly desirable in terms of macroeconomic impact, does not help solve the problem of forecast bias. It can even make it worse. In a year when a forecast for the actual budget deficit turns out to have been over-optimistic, the government has to admit that it made a mistake, which can carry some embarrassment. In a year when a forecast for the structural budget deficit turns out to have been over-optimistic, the government can still claim that its own calculations show the shortfall to have been cyclical rather than structural. After all, estimation of potential output and hence the cyclical versus structural decomposition is notoriously, even after the fact.

The World’s Opinion Page

Help support Project Syndicate’s mission

subscribe now

Will it help that under the fiscal compact the rules are to be adopted at the national level, as opposed to the supranational level on which the SGP operated? A look at the various rules and institutions that have already been tried by European countries shows that some work and others don’t. Creating an independent fiscal institution that provides its own independent budget forecasts works, in that it reduces the bias in projections. Euro area governments with an independent budget forecasting institution have a mean bias when making forecasts while in violation of the Excessive Deficit Procedure (EDP) that is smaller by 2.7% of GDP [at the one-year horizon], compared to euro area countries that are in violation of the EDP without such an independent fiscal institution.

It would be better still if the governments were legally bound to use these independent forecasts in their budget plans (thereby borrowing an innovation from Chile).

Regardless how well-designed the rules are, clever and determined politicians can find ways around them. One of the tricks is the privatization of government enterprises which reduces the budget deficit this year on a one-time non-repeatable basis, but might raise it in the long-term if the enterprise had been earning profits. Another trick is phony legislated sunsets on tax cuts, in order to make future revenues look larger despite the political intention later to make the tax cuts permanent.

Still, other things equal, the right institutions can reduce the procyclicality of fiscal policy in the short run and help deliver debt sustainability in the long run. Examples of the right institutions are cyclically adjusted budget targets combined with independent agencies that make independent fiscal forecasts. Things can still go wrong even if such mechanisms are in place; but, as the history of the SGP illustrates, the risk is higher if they are not.

http://prosyn.org/IQpzLBU;
  1. Television sets showing a news report on Xi Jinping's speech Anthony Wallace/Getty Images

    Empowering China’s New Miracle Workers

    China’s success in the next five years will depend largely on how well the government manages the tensions underlying its complex agenda. In particular, China’s leaders will need to balance a muscular Communist Party, setting standards and protecting the public interest, with an empowered market, driving the economy into the future.

  2. United States Supreme Court Hisham Ibrahim/Getty Images

    The Sovereignty that Really Matters

    The preference of some countries to isolate themselves within their borders is anachronistic and self-defeating, but it would be a serious mistake for others, fearing contagion, to respond by imposing strict isolation. Even in states that have succumbed to reductionist discourses, much of the population has not.

  3.  The price of Euro and US dollars Daniel Leal Olivas/Getty Images

    Resurrecting Creditor Adjustment

    When the Bretton Woods Agreement was hashed out in 1944, it was agreed that countries with current-account deficits should be able to limit temporarily purchases of goods from countries running surpluses. In the ensuing 73 years, the so-called "scarce-currency clause" has been largely forgotten; but it may be time to bring it back.

  4. Leaders of the Russian Revolution in Red Square Keystone France/Getty Images

    Trump’s Republican Collaborators

    Republican leaders have a choice: they can either continue to collaborate with President Donald Trump, thereby courting disaster, or they can renounce him, finally putting their country’s democracy ahead of loyalty to their party tribe. They are hardly the first politicians to face such a decision.

  5. Angela Merkel, Theresa May and Emmanuel Macron John Thys/Getty Images

    How Money Could Unblock the Brexit Talks

    With talks on the UK's withdrawal from the EU stalled, negotiators should shift to the temporary “transition” Prime Minister Theresa May officially requested last month. Above all, the negotiators should focus immediately on the British budget contributions that will be required to make an orderly transition possible.

  6. Ksenia Sobchak Mladlen Antonov/Getty Images

    Is Vladimir Putin Losing His Grip?

    In recent decades, as President Vladimir Putin has entrenched his authority, Russia has seemed to be moving backward socially and economically. But while the Kremlin knows that it must reverse this trajectory, genuine reform would be incompatible with the kleptocratic character of Putin’s regime.

  7. Right-wing parties hold conference Thomas Lohnes/Getty Images

    Rage Against the Elites

    • With the advantage of hindsight, four recent books bring to bear diverse perspectives on the West’s current populist moment. 
    • Taken together, they help us to understand what that moment is and how it arrived, while reminding us that history is contingent, not inevitable


    Global Bookmark

    Distinguished thinkers review the world’s most important new books on politics, economics, and international affairs.

  8. Treasury Secretary Steven Mnuchin Bill Clark/Getty Images

    Don’t Bank on Bankruptcy for Banks

    As a part of their efforts to roll back the 2010 Dodd-Frank Act, congressional Republicans have approved a measure that would have courts, rather than regulators, oversee megabank bankruptcies. It is now up to the Trump administration to decide if it wants to set the stage for a repeat of the Lehman Brothers collapse in 2008.