The structural balance may guide fiscal policy pro-cyclically

The structural balance that plays a central role in the EU’s new fiscal policy legislation may guide fiscal policy in a pro-cyclical way, in other words make it stimulating in an expansion and restrictive in a recession, reveals a study by Researcher Tero Kuusi. An English translation of the research report has now been published.

The structural balance is one of the key indicators used by The European Union to supervise its Member States’ fiscal policies and to monitor that their general government deficits and debt remain within the limits set by the Maastricht Treaty. It measures the cyclically-adjusted general government balance net of one-off expenditure and revenue items.

In his study Kuusi has worked out how fiscal policy based on the measured structural balance would have performed in practice in Finland during the period 1984–2014. The study examines estimates of the structural balance using the European Commission’s calculation method and compares them with alternative fiscal policy indicators. The ETLA study was carried out as part of the implementation of the Government’s 2014 plan for analysis, assessment and research.

Based on Kuusi’s assessment it appears that the way the output gap method is applied by the European Commission requires further development. Although the European Commission uses the latest statistical methods to assess the cyclical state of the economy, measuring the output gap in real time proves to be a difficult task in practice. The capacity of the output gap method to filter out cyclical fluctuations and measure cyclical phase effects on the budgetary position is limited, which may result in an under- or overestimate of the budgetary position independent of economic cycle.

Particularly in the overheating phase of the economy in the 1980s and also in the deep economic crisis of the early 1990s, fiscal policy steering using the structural balance might have resulted in a more pro-cyclical policy than the observed policy: to stimulus in upturns and to austerity in downturns. The main explanations for this behaviour are statistical problems related to the calculation of structural unemployment and, more generally, the limited capacity of the method to predict cyclical changes in real time. On the other hand, the study shows that discretionary assessment methods examined as methodological alternatives may steer fiscal policy in a more counter-cyclical direction.

Identifying and distinguishing structural changes from cyclical factors is important, because economic policy should react to permanent changes in a different way than to transitory shocks. It is often sensible to balance a cyclical shock counter-cyclically by temporarily adjusting public spending and debt. A structural shock, on the other hand, has long-term consequences for public finances, and so structural changes are the appropriate response. Uncertainty about the nature of shocks may lead to difficult and contradictory policy recommendations as far as the implementation of fiscal policy is concerned.

Inquiries: Tero Kuusi, Researcher, Research Institute of the Finnish Economy (ETLA), tel. +358 41 444 8144, and Sari Löytökorpi, Project Manager (Government’s Analysis, Assessment and Research Activities), Prime Minister’s Office, tel. +358 295 160 187

Download the research report Alternatives for Measuring Structural Budgetary Position as a pdf file.

Information on Government’s analysis, assessment and research activities