Un­nec­es­sary in­sta­bil­ity

Financial Mirror (Cyprus) - - FRONT PAGE -

In nor­mal life, tech­ni­cal­i­ties are bet­ter left to tech­ni­cians. A car owner does not need – or usu­ally want – to bother to find out what ex­actly goes on un­der the hood. But when the car breaks down, he or she of­ten has no choice.

What is true of cars ap­plies to the econ­omy: ar­cane is­sues are for spe­cial­ists. Yet in re­cent years, top­ics about which most peo­ple had never heard or cared – for ex­am­ple, se­cu­ri­ti­sa­tion, credit de­fault swaps, and the Euro­pean pay­ment sys­tem known as Tar­get 2 – have i mposed them­selves on public de­bate, forc­ing or­di­nary peo­ple to grap­ple with their in­tri­ca­cies.

The same has started to hap­pen with the no­tion of “po­ten­tial out­put growth.” Orig­i­nally a con­cept cre­ated by econ­o­mists for econ­o­mists, its use for de­ter­min­ing when, and by how much, a public deficit must be cor­rected is be­com­ing a mat­ter for wider dis­cus­sion. In­deed, its un­re­li­a­bil­ity is se­ri­ously weak­en­ing the EU’s fis­cal pact – which makes it nec­es­sary to open the hood and look in­side.

The aim of the con­cept of po­ten­tial – as op­posed to ac­tual – GDP is to take into ac­count that, like an en­gine, an econ­omy of­ten op­er­ates be­low or above po­ten­tial. In a de­mand-driven re­ces­sion, ac­tual out­put falls be­low po­ten­tial, which re­sults in a rise in un­em­ploy­ment. Sim­i­larly, a cred­it­fu­eled con­struc­tion boom drives out­put above po­ten­tial, re­sult­ing in in­fla­tion.

The gap be­tween ac­tual and po­ten­tial GDP is thus a gauge of an econ­omy’s spare ca­pac­ity. The distinc­tion is also use­ful for pol­icy pur­poses: weak po­ten­tial growth can­not be ad­dressed by de­mand-side ini­tia­tives; sup­ply-side mea­sures are needed.

But po­ten­tial GDP can be only es­ti­mated, not ob­served. Es­ti­mates are based on the amount of la­bor and cap­i­tal avail­able for pro­duc­tion and an as­sess­ment of their joint pro­duc­tiv­ity. And, be­cause es­ti­mates dif­fer, depend­ing on the data and meth­ods used, the con­cept is clear whereas its value is im­pre­cise.

More­over, the global fi­nan­cial cri­sis has cre­ated new puzzles. GDP in nearly all ad­vanced economies is cur­rently far be­low pre-cri­sis pro­jec­tions, yet few ex­pect the gap ever to be bridged. Pol­i­cy­mak­ers strug­gle to get their as­sess­ment right. Some won­der what is left of the no­tion of po­ten­tial out­put.

The Euro­pean Union has an ad­di­tional prob­lem: in re­sponse to the sovereign cri­sis, most of its mem­bers agreed in 2011 to a “fis­cal com­pact” re­quir­ing them to keep their struc­tural bud­get deficit – the one they would record were out­put equal to po­ten­tial – be­low 0.5% of GDP. Fail­ure to con­verge on this tar­get may open the door to fi­nan­cial penal­ties.

The virtue of such a frame­work is to take into ac­count the im­pact of tem­po­rar­ily weaker out­put on fis­cal out­comes. Thus, a deficit is ac­cept­able when it re­sults from ab­nor­mally low tax rev­enues, but not when rev­enues are at their nor­mal level.

In­deed, a ma­jor flaw in the ini­tial Euro­pean Sta­bil­ity and Growth Pact was that it did not in­clude such cor­rec­tions (I was among those ad­vo­cat­ing its re­form in a 2003 re­port to the pres­i­dent of the Euro­pean Com­mis­sion). The 2011 treaty ac­tu­ally built on a se­ries of pre­vi­ous re­forms that put in­creas­ing em­pha­sis on po­ten­tial-out­put-based as­sess­ments of the fis­cal sit­u­a­tion.

The prob­lem is that an un­ob­serv­able and im­pre­cise vari­able – whose es­ti­mates are too in­ex­act and volatile to pro­vide more than a rough roadmap for a coun­try’s jour­ney to­ward fis­cal rec­ti­tude – has be­come part of an in­ter­na­tional treaty and the na­tional rules (some­times of con­sti­tu­tional sta­tus) through which it is im­ple­mented.

Es­ti­mates of short-term or cur­rent po­ten­tial out­put are also con­stantly re­worked, im­ply­ing con­tin­u­ous change in the as­sess­ment of the un­der­ly­ing fis­cal sit­u­a­tion. For ex­am­ple, the Euro­pean Com­mis­sion’s pro­jec­tion of the Nether­lands’ po­ten­tial growth for 2013 was 0.9% in spring 2012, when the gov­ern­ment started pre­par­ing its bud­get. By that au­tumn, when a real-time as­sess­ment of fis­cal per­for­mance was car­ried out, it had been re­vised sharply down­ward, by 0.2%. For France, the es­ti­mate fell from 1.2% to 0.9%, and for Italy it went from -0.1% to -0.4%. The es­ti­mate of Spain’s po­ten­tial growth rate fell from -1.2% to -1.4%, but the Com­mis­sion later changed its mind and now says it was -0.7%. Th­ese are not ex­cep­tions.

For ac­tual GDP, such fre­quent and large fore­cast re­vi­sions are in­evitable. Po­ten­tial GDP, how­ever, is sup­posed to be more sta­ble, as it does not de­pend on de­mand-side de­vel­op­ments.

True, there are rea­sons to re­assess a coun­try’s po­ten­tial growth in line with new in­for­ma­tion on la­bor-mar­ket con­di­tions, in­vest­ment, and pro­duc­tiv­ity. But re­lent­less at­tempts at ac­cu­racy eas­ily re­sult in noise.

Fur­ther­more, in­sta­bil­ity con­fuses the pol­i­cy­mak­ing process. Even a down­ward re­vi­sion by 0.2% of GDP is mean­ing­ful: it im­plies a de­te­ri­o­ra­tion of the struc­tural deficit by about 0.1% of GDP – not a triv­ial num­ber in a fis­cally con­strained en­vi­ron­ment.

Mem­bers of par­lia­ment – who are not tech­ni­cians – are un­der­stand­ably dis­turbed when they are asked to pass a re­vised bud­get in re­sponse to an up­dated es­ti­mate. Not know­ing the whys and where­fores, they end up per­ceiv­ing such re­vi­sions as a source of ar­ti­fi­cial in­sta­bil­ity.

The pur­pose of the Euro­pean fis­cal frame­work is to lengthen the time hori­zon of pol­icy and to make de­ci­sion­mak­ers more aware of the debt-sus­tain­abil­ity chal­lenges that they face. This re­quires con­sis­tency. Yet volatil­ity in the as­sess­ment of po­ten­tial growth pre­vents politi­cians from “own­ing” the al­ready ab­struse struc­tural deficit and causes volatil­ity in the poli­cies based on this as­sess­ment, para­dox­i­cally re­sult­ing in a short­en­ing of de­ci­sion-mak­ers’ time hori­zon. The fo­cus of pol­icy dis­cus­sions should not be the lat­est po­ten­tial GDP re­vi­sion, but whether a coun­try is on track to en­sure public fi­nance sus­tain­abil­ity.

Too of­ten, the Euro­pean fis­cal pact is per­ceived by na­tional pol­i­cy­mak­ers as an ex­ter­nal con­straint, not as a frame­work con­ducive to bet­ter de­ci­sions. A greater de­gree of sta­bil­ity in the as­sess­ment of an econ­omy’s po­ten­tial would strengthen de­ci­sion-mak­ers’ aware­ness and ap­pre­ci­a­tion of longer-term chal­lenges, thereby putting pol­i­cy­mak­ing on a sounder foot­ing.

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