The new fiscal control regime imposed on euro area countries attaches great importance to the structural deficit, i.e. the deficit net of the effects of the economic cycle and of one-off measures, which should mitigate its pro-cyclical aspects. However, structural balance estimates are closely linked with estimated potential GDP and output gap, and the European Commission seems to consider the slowdown in economic activity observed in recent years more structural than cyclical…
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An underestimation of the output gap results in an underestimation of the portion of the deficit tied to the economic cycle, and therefore in the imposition of excessive structural consolidation on countries experiencing deep recessions.
Within the framework of the European semester, which began last January, the Commission must assess the adequacy of the fiscal consolidation and structural reform plans in relation to the medium-term objectives agreed upon at the Community level. In particular, Member States are waiting to receive the Commission’s recommendations on the updating of their Stability Programmes. The Commission will publish its opinions on 29 May, and following the Council’s scrutiny, the Member States will have to embrace the recommendations. In some cases, if the fiscal effort being made is deemed inadequate, the Commission may request an additional correction of public finance balances.
In general, both the new Stability Pact and the Fiscal compact place greater emphasis on the consolidation of “structural” balances, i.e. net of the effects of the economic cycle and of one-off measures. The goal is achievement of a structural deficit no higher than 1%, or 0.5% for countries that have signed the Fiscal Compact. The Stability Pact imposes an improvement in the structural balance of at least 0.5% a year on low-debt countries with a deficit of close to 3%, and a stronger consolidation effort if debt is significantly higher than 60%. The deviation is significant if equal to 0.5% in one year or 0.25% over two years in terms of balance, limits that may be exceeded only in “exceptional circumstances”. In this context, estimation of an economy’s position in relation to its potential growth, the co-called output gap, becomes especially relevant. However, as also acknowledged by the Commission itself, output gap estimates are typically subject to a significant margin of discretion, tied in part to the difficulty in defining and estimating long-term structural unemployment, and the trend of investments. The methodology used by the European Commission to estimate potential growth and the output gap was defined by a dedicated working group (OGWG).
The weight assigned to the cycle in the consolidation of public balances varies depending on whether larger or smaller output gap estimates are used. The cyclical component of the deficit is determined based on the interaction of elasticity to the cycle with the output gap. The wider the output gap, the larger the cyclical component, and vice versa. The problem is that for countries facing a recession, the output gap estimates provided by the Commission are lower than those drawn up by other institutions, such as the OECD. An underestimation of the output gap may therefore result in an underestimation of the cyclical component of the deficit, and in the imposition of excessive structural consolidation in a recessive phase.
Let’s consider the case of Spain, where the positions of the different authorities are more distant. The Commission estimates the output gap at -4.6 points in 2012-2013, and at a narrower -2.3 in 2014, whereas the Spanish government, which adopts a methodology that is more similar to the OECD’s, estimates the output gap at around -8 points between 2012 and 2014. In the Commission’s estimates, the cyclical component of the deficit is 2.2% points of GDP in 2012-2013, and 1.1 points in 2014, and the structural balance is estimated at -5.5% in 2014 (unchanged vs. 2012). In the government’s estimates, on the other hand, the weight of the cyclical component is markedly greater (-3.5%), and as a result the structural deficit is smaller: -1.8% in 2014, down from -4.3% in 2012. Spain’s Stability Programme for 2013-16, therefore, proposes a much smaller structural consolidation than implied by the Commission’s estimates. The difference in the output gap is due to the estimate of potential GDP, which according to the Commission should drop by -1.3 points a year between 2012 and 2014 (from +3.1% on average in the 2000–08 period), as opposed to an estimated -0.3% decline according to the government.
Appendix
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