How not to run fiscal policy: more lessons from the Eurozone

In my last but one post I noted the case of European Commission estimates of the output gap as an example of what can happen if you do not allow for the asymmetry implied by firms’ reluctance to cut nominal wages. Their methodology implied that the natural rate in Spain had more than doubled in a decade, which seems nonsensical. However the economists at the Commission at least came to recognise the problem, and had proposed making some changes to get more reasonable numbers. As I will explain, the methodology they use is reasonable given the state of macroeconomic arts, which is why in that earlier post I used this as an example of a failure of macroeconomics generally, rather than economists at the Commission. In this post I want to note what happened next, which in contrast does seem to reflect badly on how the Commission works.

But before getting to that, a few background points. First why this matters. As part of the “two pack” (don’t ask), Eurozone economies will now have to submit their budgets for approval by the Commission. Approval will depend, among other things, on the Commissions calculations of the structural budget deficit, which is the deficit corrected for the cycle. Measuring this is difficult, because we do not observe the output gap, which itself depends on both the natural rate of unemployment and the underlying trend in productivity (technical progress), which we also do not observe.

You can say at this point why bother - just stick to looking at the actual deficit. That’s an overreaction. For most Eurozone countries we are pretty clear about the sign of the output gap, so making some adjustment should be better than doing nothing. To see the kind of stupidity that arises from just focusing on actual deficits, see the Netherlands.

In principle we can use information on what we do observe, like wage inflation, to make inferences about what the natural rate of unemployment is. So if wage inflation depends on the gap between actual unemployment and the natural rate (called the NAWRU by the Commission), we can switch things around to make this an equation telling us what the natural rate is, given observations on actual wage inflation.

There are three kinds of problem that arise in doing this. The first is that our estimates will be only be as good as the specification of the wage equation. If we leave important factors out of the specification of the wage equation (like a reluctance to cut the nominal wages of existing workers because of morale effects - see this paper by Eliaz and Spiegler for example), we will get our estimates of the natural rate wrong. The second is that some of the things that we are sure do determine wage inflation, like inflation expectations, may be difficult to measure. Paul Krugman discusses the possibility that inflation expectations in Spain might have become anchored here. Finally no equation is perfect, and if we do not allow for these inevitable errors we will get a ridiculously bumpy series for the natural rate. So we need to apply some kind of smoothing.

The way the Commission tackled these problems is described in detail here. The fact that they use a Kalman filter to deal with smoothing issues seems sensible to me: I’m quite fond of the Kalman filter, ever since I wrote a paper with Andrew Harvey, Brian Henry and Simon Peters that used it to estimate labour productivity back in 1986. [1] I suspect they are getting the implausible results for one of the other two reasons. But the key thing to take away is that there are no easy answers here, and this kind of problem requires quite specific macroeconomic expertise. Furthermore, the importance of particular issues may vary between countries, so country specific expertise should be helpful.

Following on from this last point, it is clear that this is not just an issue for Spain. As the Irish Fiscal Advisory Council notes here (p68), the Commission estimates for the natural rate in Ireland also look implausibly high. So it is not surprising that the Commission would want to adjust their methodology to give more plausible numbers. (Matthew Dalton looks at the implications of their methodology for the US here.)

This all matters. If the Commission underestimates the output gap because it overestimates the natural rate of unemployment, then it will overestimate the structural budget deficit, and the country concerned will come under considerable pressure to undertake further austerity. Readers will know why I think that will be a very costly outcome. (More on this from Cohen-Setton and Valla here.)

At least economists at the Commission have now recognised the problem, and changed their estimates. But as Matthew Dalton reports

“The change was approved by technical experts at a meeting last week and was expected to be supported at a Tuesday meeting of more senior officials in Brussels. But an article published in The Wall Street Journal about last week's decision generated concern in some national capitals about its effects on budget policies, an EU official said. The new methodology will be sent back to the expert committee for further discussions, in an effort to understand what its impact will be on all 28 EU countries, the official said.”

Reassuringly, Dalton adds that "The commission is fully on board with the new methodology," the official said. "We believe it is superior." But he also notes that the new methodology “was supposed to have been used by the commission in its next round of estimates of the structural deficit, to be published in November. Now that will have to wait, if it is approved at all.” As one of my commentators pointed out, this article in a leading German newspaper may have contributed to this official hesitation.

So the Commission will go on making estimates that it knows are overestimating structural budget deficits, because of ‘concern in some capitals’ about the implications of using better estimates! None of this does the Commission any good in terms of its competence to help determine national fiscal policy. (Of course nothing can top the incompetence recently shown by the US congress, but that is no excuse.) 

Luckily there is an obviously better way to proceed, even within the confines of the deeply flawed Fiscal Compact. Many Eurozone countries already have their own ‘fiscal councils’: independent bodies set up to provide scrutiny of national fiscal policy. It should be central to the mission of these bodies to estimate the output gap and structural deficit, as it is impossible to look at fiscal sustainability without doing so. So why not get estimates of the output gap from these institutions who will be able to take into account country specific factors, and use the academic expertise that exists in those countries to maximum effect. (Spain and Ireland are hardly short of good macroeconomists.) Unlike the governments of those countries, fiscal councils should not be prone to bias in producing these estimates. The Commission can play a coordinating role, getting experts from the national fiscal councils together to share ideas and expertise. This seems to me a clearly better way to proceed, unless of course your goal is to maximise the influence of the Commission.

[1] Harvey, A., Henry, S.G.B., Peters, S. and Wren-Lewis, S. (1986), Stochastic trends in dynamic regression models: an application to the employment output relationship, Economic Journal, vol 96 pp 975-985.