The voting public must be getting frustrated with the wildly conflicting claims of politicians and economists on consequences of accepting/rejecting the Fiscal Treaty. As some of the consequences are genuinely uncertain – notably access to funding if the Treaty is rejected – conflicting assessments of consequences are not really surprising. But the public are also being subjected to some wild claims relating to the budgetary arithmetic of meeting the fiscal rules – rules already in place under the revised Stability and Growth Pact. It might be worthwhile to take a closer look at the numbers.
To get a sense of the likely additional fiscal effort required to meet the 1/20th and structural balance rules, a useful starting point is the most recent Government projections for the period to 2015 just published in the Stability Programme Update (SPU). Of course, as these are just projections; the actual situation in 2015 may be quite different. But examining what extra discretionary adjustment effort would be needed helps identify a rough order of magnitude, and hopefully weed out some wilder assertions. For reference, details of the implementation of the Stability and Growth Pact rules are available here.
The 1/20th Rule
The actual application of the rule uses both backward and forward looking averaging. To keep things as simple as possible, I will just look at the rate of debt reduction in the current year.
The change in the debt/GDP ratio is given by a simple formula:
Δd = [(i – g)/(1 + g)]d-1 – ps,
where d is the debt/GDP ratio (in percent of GDP), i is the average nominal interest rate on outstanding debt, g is the nominal growth rate, d-1 is the previous year’s debt/GDP ratio, and ps is the primary surplus (in percent of GDP).
We can use the projections in the just published SPU to get a sense of the projected underlying rate of debt ratio reduction in 2015. The lagged debt/GDP ratio (2014) is 119.5 percent of GDP, the nominal interest rate is 0.049, the nominal growth rate is 0.045, and the primary surplus is 2.8 percent of GDP. This yields a projected underlying fall in the debt/GDP ratio of 2.3 percentage points of GDP in 2015. (The actual fall projected in the SPU is 2.1 percentage points due to a stock-flow adjustment.) This suggests a further total improvement in the primary surplus equal to 0.7 percentage points of GDP would be sufficient to achieve the required 3 percentage-point reduction rate [(1/20)(119.5 – 60)]. Moreover, all else equal, the primary surplus as a share of GDP required to meet the rule declines as the debt/GDP ratio declines.
The Structural Balance Rule
The structural balance rule requires the structural deficit to be brought down to 0.5 percent of GDP. The Stability Programme Update projects a structural deficit of 3.5 percent of GDP in 2015. The implied nominal structural deficit is €6.3 billion. The nominal structural deficit consistent with the 0.5 limit (Ireland’s Medium-Term Budgetary Objective, which is the operational definition of structural balance) is €0.9 billion. The difference – €5.4 billion – might seem to suggest a large additional adjustment is required. But this ignores the impact of growth in nominal potential/actual GDP in subsequent years in bringing down the structural deficit in the absence of any discretionary adjustments.
Growth affects both the denominator and the numerator of the structural deficit as a share of GDP. (For simplicity I assume that actual and potential GDP grow at equal rates post 2015.) The denominator effect is straightforward. For the numerator, we could use the standard coefficient used by the European Commission for Ireland that assumes that the reduction in the deficit is 0.4 times the change in nominal GDP. (This coefficient is usually used for doing cyclical adjustments, but it should also be applicable for measuring the impact of changes in nominal potential GDP on structural balance in the absence of discretionary adjustments to tax and expenditure parameters.) However, to err on the conservative side, I assume a coefficient of just 0.2 for the calculations. The SPU projections imply a nominal growth rate for potential GDP of 3.16 percent in 2015. Assuming this growth rate remained constant for subsequent years (which again seems conservative), even with no further post-2015 discretionary adjustments the structural deficit as a share of GDP is projected to fall to 0.8 percent of GDP in 2019 and to 0.2 percent in 2020.
There’s many a slip twixt cup and lip – but hopefully these benchmark calculations can help identify some of the wilder budgetary arithmetic.