Who needs structural deficits?

With the onset of the Great Recession, European Union (EU) governments loosened their purse strings and let automatic stabilizers operate, predictably swelling their budget deficits in the hope that rising public spending would get the economic engine going again. But the constraints on growth in most EU economies have always been structural rather than cyclical, and further expansion of government spending in response to the crisis has only led to a build-up of debt.

Countries like Italy, Greece, and Portugal suffered from chronic deficits even before the crisis began, while others (like Ireland) increased their spending significantly only in the years after the Lehman Brothers bankruptcy.

Budget deficits in selected euro area countries, % of GDP

The countercyclical fiscal policy of governments is reflected in the so-called structural balance, which is used in the EU to determine the measures, size and scope of fiscal consolidation implemented when a country has overstretched its budget. The structural balance is the difference between a country's revenue and expenditure, without taking into account the effects on the budget of the economic cycle and one-off measures such as (for example) the recapitalisation of the banking system. In the context of cyclicality, the structural balance should "clean up" the effect on the fiscal budget of higher expenditure and lower revenue during a recession, resulting from falling tax revenues and rising transfer payments (unemployment benefits, for example).

Looking a little deeper into the EU's methodology for calculating structural balances and the results that the models used produce, one easily comes to the conclusion that the deficit in the Union is more of a brain than a structural one. In order to calculate the structural balance of a country's budget, quantitative estimates must be given of:

1. The potential economic growth that is achieved when all resources in the economy are used. The difference between potential growth and actual growth for a given period is called the potential GDP gap.
2. The impact of this deviation on the fiscal;
3. One-off measures and their impact on the fiscal system.

But things don't end there. To calculate potential GDP, a production function is used that includes three variables: capital, labor, and total factor productivity. The following assumptions are made:

1. Capital is measured as the value of the accumulated capital stock, i.e. the value of investments made minus depreciation;
2. For the labor variable, a measure of the equilibrium unemployment rate is used, which is calculated using statistical methods;
3. Total factor productivity is calculated as the residual of an econometric model that calculates the contribution of capital and labor to the actual gross product produced. To calculate potential GDP, it is assumed that productivity changes gradually over time and again statistical models are applied to make the calculations.

One does not need to be a nuclear physicist to see the shortcomings of structural balance calculations, which are mainly expressed in the use of multiple variables and models with assumptions. The failure of the entire concept is even more obvious when we look at some of the results obtained using this methodology.

According to the EU, the equilibrium unemployment rate in Spain in 2013 was 23.7%, which is not much below the real one, which is expected to be around 27% at the end of the year. For 2014, the results are even more striking, when the equilibrium unemployment rate is 25.9%, and the forecasts for the reported unemployment put it at levels of around 26.4%. In Ireland, the reported unemployment rate next year will fall below the equilibrium one, which means that there will be excess employment - i.e. to the detriment of the economy.

Moreover, the estimates of the equilibrium unemployment rate and potential GDP for each country are constantly changing. In 2007, the EU estimated that the equilibrium unemployment rate in Latvia was 6.3%, but this year it changed its already old estimate to 11.4%. When it comes to the potential GDP size, the results are even more startling. In 2007, the EU estimated that the deviation from Latvia's potential GDP was 1%, in 2009-2012 this estimate jumped to 14-15%. You can guess what change in the amount of fiscal consolidation this difference leads to.

As for capital, the main drawback of calculating structural balances is that it calculates the value of the accumulated capital stock at the moment, i.e. it does not take into account the possibility that a large part of this capital is the result of bad entrepreneurial decisions (malinvestment) and is unnecessary. A typical example is the bloated construction sector before the crisis in countries such as Spain and Ireland, where favorable lending conditions (created largely due to the adoption of the single European currency by these countries) led to a construction boom and a lot of bad investments.

The shortcomings of the EU model for calculating structural balances are many, but first of all, it is worth asking ourselves what the point of such an indicator is? What is “unusual” or “one-off” about a recapitalization of the banking system when it was a political decision? What is “unusual” about social welfare spending rising during a recession after politicians have decided what the size of the welfare state should be, most likely under pressure from a cohesive and well-organized group in society (how well democracy works!)? This is nothing more than another tool in the hands of bureaucrats in Brussels with which to carry out social engineering.

Sources:

http://www.bruegel.org/nc/blog/detail/article/1170-mind-the-gap-and-the-way-structural-budget-balances-are-calculated/

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