Estimation errors with dire consequences

20 October 2020

In EU fiscal surveillance, errors produced by an estimation model have led to excessive fiscal consolidation pressure. After the southern countries, this will soon affect Germany and Austria as well.

by Philipp Heimberger

In a recent speech, the president of the European Central Bank (ECB) made an important side note, which received little media attention. It contained a scathing judgment on key elements of EU fiscal surveillance over the last decade. Christine Lagarde admitted that the models used as a basis for assessing national fiscal policies have systematically underestimated under-utilisation of economic resources, also known as the output gap. After the financial crisis of 2007/2008, the models misinterpreted the decline in GDP due to the economic downturn as a "structural" reduction in potential output.

Potential output is an estimate of how much an economy can produce without creating inflation pressures. A gap between actual output and the calculated potential output indicates under-utilisation of existing production factors. More could be produced without the risk of overheating and inflation: a large output gap is seen as an indicator that fiscal policy measures could be useful to stimulate the economy. The output gap is therefore directly taken into account in the assessment of the fiscal stance. Countries with a large output gap are allowed to run higher fiscal deficits.

The ECB president referred to research results suggesting that policymakers pushed too hard for fiscal consolidation in the aftermath of the financial crisis of 2007/08 – because of systematically mismeasuring output gaps as too small. In Italy and Spain, the model estimates implied that almost all unemployment was "structural", i.e. not caused by cyclical factors. This promoted excessive cuts in government spending and tax increases, resulting in lower growth, higher unemployment and declining tax revenues.

Before Corona, the Commission saw no output gap in Italy – despite an unemployment rate close to 10% and very low inflation. The entire fiscal deficit was considered "structural". The Italian government had to impose further spending cuts in order to meet the EU’s budget targets.

Why should all of this be relevant for countries such as Germany or Austria? Although the estimation problems are well known in research, the European Commission has already revised the size of the output gap for the next year downwards. As soon as the escape clauses, which currently still suspend the fiscal rules, no longer apply, this underestimation of the output gap will have a very concrete consequence - namely the restriction of the space available to fiscal policy-makers in Germany and Austria to support the recovery from the Corona recession. The deficit limits stipulated in national “debt brakes” are also directly based on the problematic output gap estimates from Lagarde's speech. Economists and policymakers in Germany and Austria should therefore study the ECB President's side note with particular care.

Note: Translated and adapted from a comment that first appeared in “Handelsblatt”. The original article is here (in German).