The Econometrics of the EU Fiscal Governance: is the European Commission methodology still adequate?

Fioramanti, Marco and Waldmann, Robert J. (2017): The Econometrics of the EU Fiscal Governance: is the European Commission methodology still adequate? Forthcoming in: Rivista Internazionale di Scienze Sociali

Abstract

Following the 2005 regulations emending the Stability and Growth Pact with the introduction of country-specific objectives in structural terms, the EU fiscal governance is based on the concept of Potential Output, the highest level of production an economy can sustain without incurring inflationary pressure. Potential Output is an unobservable quantity and, for this reason, it must be estimated. There are many techniques to obtain an estimate of the potential of an economy, each of which with pros and cons. The methodology adopted by the European Commission and EU Member States, while consistent with most of the recent economic and econometric theory, is still not robust enough to give a unique and irrefutable measure on which to base EU’s fiscal framework. In this paper, we challenge the EC's approach showing its failure to adequately capture the relation between inflation and cyclical unemployment, the Phillips curve, in estimating the trend unemployment. Should fiscal policy continue to be based on this concept, further extension of the methodology must be implemented in order to obtain more robust estimates.

• Item Type: MPRA Paper
• Language: English
• Keywords: Potential output, Output gap, Structural balance, NAWRU, Phillips curve
• Subjects: C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C10 - General; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E60 - General; H - Public Economics > H6 - National Budget, Deficit, and Debt > H60 - General

References

Bassanetti A., Caivano M. and Locarno A. (2010) “Modelling Italian potential output and the output gap”, Banca d’Italia - Working Paper N. 771.

Blanchard O., Cerruti E. and Summers L. (2015) “Inflation and Activity – Two Explorations and their Monetary Policy Implications”, IMF Working Paper 15/230.

Brainard L. (2017) "Understanding the Disconnect between Employment and Inflation with a Low Neutral Rate", speech at the Economic Club of New York, 5th September.

Cerra V. and Saxena S.C. (2000) “Alternative Methods of Estimating Potential Output and the Output Gap: An Application to Sweden”, IMF – Working Paper N. 59.

European Commission (2015) “Making the Best Use of the Flexibility within the Existing Rules of the Stability and Growth pact”, COM(2015) 12 final.

European Commission (2016a) “Vade Mecum on the Stability and Growth Pact”, European Economy – Institutional Paper N. 021, March.

European commission (2017) “Spring 2017 Economic Forecast: Navigating through Choppy Waters”, European Economy – Institutional Paper N. 20, February.

Fabiani S. and Mestre R. (2004) “A System Approach for Measuring the Euro Area NAIRU”, Empirical Economics N. 29, pg. 311-341.

Fioramanti M. (2017) "Potential Output, Output Gap and Fiscal Stance: is the EC estimation of the NAWRU too sensitive to be reliable?", in Ginebri S. Italian Fiscal Policy Review 2015, Ed. RomaTrE-Press.

Fioramanti M., González-Cabanillas L., Roelstraete B. and Ferrandis-Vallterra S.A. (2016) "European Commission's Forecasts Accuracy Revisited: Statistical Properties and Possible Causes of Forecast Errors", European Economy - Discussion Paper N.027.

Fioramanti M. and Waldmann R.J. (2016) "The Stability and Growth Pact: Econometrics and its consequences for human beings", Vox column appeared on-line on VoxEU.org, 19 November 2017.

Gordon R. (1997) “The time-varying NAIRU and its implications for economic policy”. Journal of Economic Perspectives N. 11(1), pg. 11-32.

Havik K., Mc Morrow K., Orlandi F., Planas C., Raciborski R., Roeger W., Rossi A., Thum-Thysen A., Vandermeulen V. (2014) “The Production Function Methodology for Calculating Potential Growth Rates & Output Gaps”, European Economy, Economic Paper N. 535.

Hristov A. and Roeger W (2017) "On the Econometrics with a Human Face and Business Cycle: A Reply to Fioramanti and Waldmann's Criticism on the EU's NAWRU Methodology", European Economy - Economic Brief N. 022.

Ministero dell’Economia e delle Finanze (2015) Economic and Financial Document 2015, Section I: Italy’s Stability Programme.

Mourre G., Astarita C. and Princen S. (2014) “Adjusting the budget balance for the business cycle: the EU methodology”, European Economy - Economic Papers N. 536.

Roubini, N. (2017) "The Mystery of the Missing Inflation", Project Syndicate, 13th September.

Planas C., Roeger W. and Rossi, A. (2013), “The information content of capacity utilization for detrending total factor productivity”, Journal of Economic Dynamic and Control, 37, 577-590.

Planas C. and Rossi A. (2015) “Program GAP: Technical Description and User Manual”, JRC Scientific and Technical report, May, version 4.4.

Price R.W., Dang T.T. and Guillemette Y. (2014) “New Tax and Expenditure Elasticity Estimates for EU Budget Surveillance”, OECD Economics Department Working Papers N. 1174.

Proietti T., Musso A. and Westermann T. (2004) “Estimating Potential Output and the Output gap in the Euro Area: a Model-Based Production Function Approach”, Empirical Economics N. 33, pg. 85-113.

Richardson P., Boone L., C. Giorno C., Meacci M., Rae D., and Turner D. (2000), "The Concept, Policy Use and Measurement of Structural Unemployment: Estimating a Time Varying NAIRU Across 21 OECD Countries," OECD Economics Department Working Papers N. 250.

Rusticelli E. (2015) “Rescuing the Phillips curve: Making use of long-term unemployment in the measurement of the NAIRU”, OECD Economic Journal, Vol. 2014, N. 6/1.

Rusticelli E., Turner D. and Cavalieri M.C. (2015) “Incorporating Anchored Inflation Expectations in the Phillips Curve and in the Derivation of OECD Measures of Equilibrium Unemployment”, OECD Economic Department Working Papers N. 1231.