Gavin Barrett tries to clarify some issues in this IT op-ed.
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I would usually include this as a comment on my previous post. Philip has urged us to put more substantive comments as new posts on the grounds that many readers do not read the comments – I hope that is not true.
Commenters have rightly pointed to the substantial uncertainty surrounding the growth projections in the SPU. Kevin’s post also puts a question mark over near-term projections. This uncertainty is a major theme of the IFAC’s recent Fiscal Assessment Report (available here). Although it is benchmarked on the projections in Budget 2012 rather than recently released SPU, one of the things we do in the report is examine the budgetary implications out to 2015 of alternative nominal growth assumptions. The Figures on page 34 provide a sensitivity analysis based on a relatively simple simulation model that allows for two-way causality between the deficit and the state of the economy. Figure 3.3.c shows the implied additional discretionary adjustments that would be required to meet the EDP target of a deficit below 3 percent of GDP in 2015 based on alternative nominal growth assumptions.
On the question of the need for a less contractionary fiscal stance for the euro zone as a whole that Kevin emphasises, Simon Wren-Lewis had a typically thoughtful piece a couple of weeks back on the constraints on fiscal policy within the monetary union (see here). Unfortunately, I am sceptical that much will be forthcoming in this direction. While I am under no illusions about the massive – some might say impossible – political challenge, I think the best route to ease the contractionary forces within the euro zone still remain with the ECB. A credible commitment to a higher euro zone inflation target (say 4 percent) – or, even better, and price-level target based on underlying 4 percent inflation – offers a real opportunity.
While there are downsides, this revised target could accomplish a number of things: (i) with a clear mandate to achieve this single target, it is compatible with a reasonable definition of price stability; (ii) it would allow for lower real interest rates, thereby boosting interest-sensitive spending; (iii) given inevitable nominal rigidities, it would allow for a more feasible route to real exchange rate depreciations in the periphery relative to the core; (iv) it should lead to a nominal depreciation of the euro, allowing further trade-weighted real depreciation for the periphery; (v) it would help ease real debt burdens; and (vi) it would help ease the overall euro zone budget constraint through higher seigniorage revenues.
I am probably more sympathetic than many readers to the concerns of stronger euro zone countries over the large contingent liabilities and moral hazard problems that come with substantially beefed up mutual fiscal support mechanisms. But, while recognising the value that countries place on price stability, the extent of the euro-zone crisis means that a higher inflation target appears to score well on any reasonable cost-benefit analysis. Some (sensible) radicalism is badly needed.
The referendum2012.ie site is now live.
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.