Potentially less austerity for the troubled Eurozone

Could a new method of measuring structural deficits mean easing austerity pressures on troubled Eurozone economies? Chema Sanz via Flickr

The EU Commission’s autumn economic forecasts are due tomorrow.

What makes this event special this year is that there are rumours about a possible change in the Commission’s approach to calculating the so-called ‘output gap’.

An EU working group has now proposed changes to the calculation of this metric - but these are yet to be approved.

What sounds like a very technical issue could not only have important economic consequences for crisis-affected Eurozone countries, such as Spain, Ireland, Portugal and Greece. It may also have serious political implications for the entire Eurozone.

New metrics, new policies

Let’s start by looking at the economic consequences of any sort of change.

The ‘output gap’ is a metric that indicates how far an economy is away from its ‘normal’ level of production. Changing how this is measured has direct consequences for evaluating the fiscal balance of a country. If a country is operating at its ‘potential’, a fiscal deficit is considered to be ‘structural’ and permanent.

The right medicine here is structural reform, such as downsizing the government sector or increasing taxes, thus confirming the appropriateness of the past EU-crisis strategy.

If, however, the crisis economies are found to be operating below their capacity, then the fiscal malaise could be considered ‘cyclical’. Less austerity, and eventually demand-stimulating measures, are then more appropriate.

In short, adopting a new method could trigger a change in policy stance towards less austerity in the Eurozone.

Is something wrong with the current method?

Take the example of Spain: The EU currently estimates Spain’s 2013 production to be just 4.6% below their potential output. But at the same time, 27% of the Spanish workforce is unemployed. How do these figures go together?

An important factor in the EU estimate of potential output is the so-called NAWRU - the ‘Non-Accelerating Wage Rate of Unemployment’.

This is, roughly speaking, the segment of the unemployment figure that is structural. This essentially means that you cannot reduce unemployment without an increased wage inflation because no worker would be willing to take the job offer unless offered a higher wage increase.

Spain’s 2013 production was only 4.6% below their potential output, but unemployment still sat at 27% EPA/Emilio Naranjo

The EU estimates the NAWRU in Spain to be at 23.7% for 2013, thus classifying almost 88% of Spanish unemployment as structural. The NAWRU was below 12% before the crisis.

Are all of these Spanish workers who have been dismissed over the last few years not willing or qualified to re-enter the labour market once the economy picks up? This diagnosis is hard to believe.

The standard methods of calculating potential GDP and NAWRU are reliable when economies are going through ‘normal’ business cycles. But as they rely, to a certain degree, on averaging more recent data they may not give us the correct information in times of extended and deep economic crises.

Rather, prolonged and deep crisis tends to adjust the NAWRU upward and the output gap downward. In other words, they may bias our diagnosis towards ‘structural problems’.

What if the problem is not structural?

In this case the austerity policy of the past would have gone too far. Many economists who are well aware of these diagnosis problems, have argued this for a long time.

For these reasons, the time for less austerity may have come. It would also be in the self-interest of the “enlightened European hegemon against his own will”, aka Germany. Its corporations are increasingly suffering from the recession in the south. And a ‘new calculation method’ could clearly help to communicate to the public in Germany and other austerity-favouring countries that austerity may have run its course.

If the problems are diagnosed as cyclical – and maybe even as having been intensified by austerity policies – this would pave the way to a more rational de-leveraging policy with ‘speed limits’, and applying the well-known wisdom that fiscal consolidation is best done in times of boom and not in times of crisis.

Who decides and monitors?

Whether or not advocates of austerity believe(d) in the structural diagnosis is a different story. But it has undoubtedly been very functional in triggering structural reforms in the problem countries.

The violation of the Stability and Growth Pact (SGP) that limits fiscal deficits to 3% of GDP turned out to be an effective lever to impose reforms. But it also raises serious concerns about the sovereignty and self-determination of democratic Eurozone member states.

In the first decade of the Eurozone the SGP fiscal criteria have often been violated, especially when Germany and France have not been able or willing to comply. And they got away with it.

The EU Commission will deliver their autumn forecast tomorrow. EPA/Julien Warand

The SGP demands the ‘actual’ fiscal deficit to be below 3% of GDP. No corrections for cyclical changes in budget are being made. This leads to the danger that during recessions, a widening deficit would call for ‘deepen-your-recession’ spending cuts or tax increases. Therefore, countries have started to negotiate with the Commission to approve the violation.

Moreover, in good times there were no rules or incentives for fiscal consolidation. Hence, the next recession often brought with it the next SGP violation.

Surely, a limit for a ‘structural deficit’ that makes use of an estimation of the potential production is the better and more rational choice, as it allows countries to react in a flexible manner to booms and busts. Such ‘next-generation fiscal rules’ are desirable from an economic point of view. In this sense the new EU fiscal compact that demands a 0.5% limit on the structural deficit should be welcomed.

However, even more than the ‘actual deficit’ metric, structural measures are vulnerable to creative ‘adjustments’. This can gear policies either towards more structural reform or less austerity.

It is therefore important that independent fiscal councils are involved in the final evaluation of what is structural and what not. The debate on this issue has only just started and involves difficult questions of how to design an effective fiscal governance system.

These issues are even more complex for the Eurozone as both national and supranational players are involved.

The real challenge for Eurozone deleveraging is not only to return to sustainable fiscal balances, but to do it without compromising the self-determination and sovereignty of member countries. At the same time it must be ensured that, in future, countries comply with the fiscal obligations they have agreed to.

In this sense, we should look forward to reading tomorrow’s autumn economic forecast with great interest.