When the diagnosis is worse than the disease

Bruegel is an excellent policy-focussed think tank based in Brussels. It doesn't seem to get much coverage or attention down our part of the world, partly because much of its work is Eurozone-centric, but it's well worth following for its analysis. I've got their blog running here in 'The latest posts from these good blogs' and here's the link if you'd like to follow it for yourself.

The latest piece on the Bruegel blog, Mind the gap! And the way structural budget balances are calculated is on a topic that's been of interest to me for some time - calculation and policy use of the structural fiscal deficit. If you're not a fiscal policy wonk, and things like the cyclically adjusted fiscal deficit or the fiscal impulse aren't at your fingertips, I wrote up some explanatory pieces based on this year's Budget here and here.

The Bruegel piece essentially says (though it's much more restrained in how it says it than I'm going to be) that the official European Union way of measuring potential output produces results that are complete nonsense. And in turn these nonsense numbers risk leading to catastrophically bad fiscal policy.

First, here's some evidence of the nonsense, as shown in a graph from the Bruegel piece.

The graph shows the EU estimates of the 'NAWRU', the Non-Accelerating Wage Rate of Unemployment. This is a key input into measuring potential output, because it is the measure used to estimate what the 'normal' or 'equilibrium' or 'trend' unemployment rate would be. This in turn gives you the 'normal' or 'trend' measure of labour supply to feed into the production function that gives you the 'normal' or 'trend' or 'potential' level of GDP.

Self-evidently, these NAWRU numbers are not to be trusted for any purposes, other than demonstrating the incoherence of their calculation. For a start, it's wholly implausible that NAWRUs could have changed so much, so quickly. It's beyond credibility that the 'normal' or 'trend' rate of unemployment in Ireland, for example, was around 4% in 2005-08 and is 15% now, and the figures for the other countries pictured are equally fantastical.

The corresponding estimates of potential output, and hence the output gap (whether there is spare capacity or whether the economy is at or beyond sustainable full capacity) are also completely off the wall. The EU's 2007 stab at it led you to believe, for example, that Ireland, at the peak of its completely over-the-top Celtic Tiger property bubble (2005-07) was operating below capacity. And the EU's 2013 estimates, made when Ireland was beginning to emerge from a very grim recession indeed, was operating 4% above full capacity.

Yeah, right.

These numbers lead you up the garden path towards dreadful fiscal policy conclusions. Or as the author of the piece puts it in a deadpan way, "If the actual unemployment rate is close to the NAWRU, actual employment is close to potential and thereby actual output is also close to potential, i.e. the output gap is small. If the output gap is small, the structural budget balance is close to the actual budget balance, and therefore a large actual budget deficit implies a similarly large structural deficit. In turn, the estimated large structural deficit requires large fiscal consolidation needs, according to the EU fiscal rules".

If you embrace these delusional numbers, you grossly overestimate the poor state of the underlying fiscal balance, and hence grossly overstate the need for austerity, while simultaneously badly misreading the state of the economy to withstand it. You believe, for example, that there's very little cyclical unemployment, and that virtually all the unemployment you actually observe is structural. Now, nobody can deny that many of the Eurozone's labour markets do not work well, and that NAWRUs are higher than they would be with better functioning ones. But even so it's very unlikely that Spain's structural or natural rate of unemployment is 25%, as these EU calculations allege.

This, to me, was a devastatingly effective critique of the EU's model. I'm sure the EU's experts are well-meaning and sophisticated modellers, but how could they have landed where they have? It leads you (among other things) to wonder whether other countries' efforts to estimate output gaps and to split fiscal balances into cyclical and structural components are equally flakey. Or, indeed, if the whole exercise is always doomed to be too unreliable to be trusted for any sensible purpose.

As it happens, we have some specific New Zealand evidence on this point, which I'll cover in my next post.