Why Europe needs to change its fiscal pact

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, securitization, credit default swaps, and the European payment system known as Target 2 – have imposed 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 credit-fueled 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 decision-makers 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 policy making on a sounder footing.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Jean Pisani-Ferry is a professor at the Hertie School of Governance in Berlin, and currently serves as the French government’s Commissioner-General for Policy Planning. 

Image: European Union flags fly outside the European Commission headquarters in Brussels. REUTERS/Thierry Roge.