Disclaimer: The views expressed are those of the author and not necessarily those of DNB Did fiscal policymakers know what they were doing? Re-assessing

Disclaimer: The views expressed are those of the author and not necessarily those of DNB

Did fiscal policymakers know what they were doing?

Re-assessing fiscal policy with real time data

Kerstin Bernoth, De Nederlandsche BankAndrew Hughes Hallett, De Nederlandsche Bank

John Lewis, De Nederlandsche Bank

CIRANO Workshop on Data Revision in Forecasting and Macroeconomic Policy

Montreal, 10 October 2008

Did Fiscal Policymakers Know What They Were Doing?Montreal, 10 October 2008 2John Lewis

De Nederlandsche Bank

Introduction

“But as is well known, the actual variables required for implementation of such a rule -potential output, nominal output, and real output-are not known with any accuracy until much later. That is, the rule does not describe a policy that the Federal Reserve could have actually followed” – Orphanides 2001

Growing literature on monetary policy rules which use real time data.

Much less attention to fiscal policy- although Orphanides’ point is just as valid– Any attempt to say what fiscal policymakers were “trying to do”

needs to take account of the information they had at the time they made the decision

– Monetary literature shows us that real time and ex post data can give quite different characterisations of policymakers’ behaviour

Literature on fiscal policy finds that discretionary policy is often a- (or even) procyclical. Is what policymakers intended?– Are fiscal policymakers misintentioned or malinformed?

If misintentioned that acyclicality should also show up in RT data



Overview

Paper makes two key contributions1. Compares fiscal policy reaction based on real time data

with their ex post counterparts2. Develops new technique using real time data to

separate out automatic from discretionary fiscal policy

Overview of Presentation– How data problems affect fiscal policymaking in real time– A simple model of fiscal policymaking in real time

The econometric problem of ex post reaction functions New methodology to split up automatic and discretionary

policy– Dataset– Estimation results– Conclusions



The Cyclicality of Fiscal Policy: A simple example

Cyclically adjusted budget balance usually used to capture discretionary policy– Strip out cyclical effect of automatic stabilisers to leave

discretionary component

Mismeasuring output gap not only the control variable but also the instrument (cyclically adjusted budget balance)

Simple example– Real time output gap +1%, ex post it turns out to be 2%– Automatic stabilisers are 0.5– Budget balance = 1% (both real time and ex post)

– Real time: CAB=+0.5%, output gap=+1% countercyclical fiscal policy

– Ex Post: CAB= 1%, output gap= 2% pro-cyclical fiscal policy

Errors reinforce each other



A first look at the data

Output gap and cyclically adjusted primary balance are prone to quite large revisions

Mean revisions to output gap and capb are approximately mean zero(Hughes Hallet et al, 2007)

Cyclically Adjusted Primary Balance (Germany), % potential GDP

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Real Time

Ex post

Output Gap (Germany), % potential GDP

-4

-3

-2

-1

0

1

2

3

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Real Time

Ex Post



A simple model of Fiscal Policymaking

Fiscal policy is set at time t+s (s=0 or -1)– First subscript is conventional one: year in question– Second subscript is the vintage of the data (f is ex post data)

Fiscal policymaker cannot directly set the cyclically adjusted balance– Instead they enact a set of spending and revenue plans, which

under certain assumptions about the economy, yield a given (cyc adj) budget balance

– Spending and revenue split up into three components

Plan:

Outturn

Expenditures fixed in cash terms(For convenience expressed as ratios to estimated pot. Output at time s)

Do not change as estimates of potential output change

Discretionary expenditures which respond to the real time output gap

Do not change as estimates of output gap revised

Automatic expenditures which respond to the true (“ex post”) level of output

Do change in response to the true output level



A simple model of Fiscal Policymaking (2)

Output and output gap measured incorrectly in real time

With some simple re-arrangement we can re-write the “final” primary balance as a function of ex post variables, measurement errors, and the policymakers desired parameters:

ex post primary balance

ex postoutput gap

“error” in real time output gap

=zt|t+s

“error” in real time potential output



Econometric Problem with Ex Post Reaction Functions

Strip out cyclical component of previous equation i.e. subtract

Standard ex post reaction function is estimated as:

– Mis-specified as a measure of policymakers intentions- omitted variables

Can test this formally: is either v or z significant? If policymaker somehow has other information from which

they can work out the “true” output gap, then coefficient on z should be zero

y~)(

“error” in real time output gap

“error” in real time potential output



Discretionary vs Automatic

Estimate the equation:

Recall:

(-) denote purely discretionary policycoefficient on output gap error captures discretionary policy(β-φ) denote purely automatic policycoefficient on ex post output gap captures sum of discretionary and

automatic fiscal policy



Taking the model to the data: The dataset

Variables:

– Cyclically Adjusted Balances

– Actual Deficits

– Primary Balances

– Output Gap

– GDP time series

– Government debt

Source: Successive issues of OECD economic outlook (Dec 94 onwards)

14 Countries: EU15 – Luxembourg



Estimation (1) We estimate the following fiscal reaction functions:

where xt|t-j = -- Debt/GDP– eyear: dummy for parliamentarian elections in year t.– “Maastricht variable” (Momigliano et al. (2004)) -

captures effect of fiscal consolidation in the run-up to EMU: For countries prior 1998 with deficit of more than 3%:

Lagged dep. variable included remove (possible) serial correlation due to persistence in budgetary variables.



Estimation (2)

To increase number of observations: Regression (a)-(d) regressed with a panel estimation.– Necessary condition: Countries are ‘poolable’: countries follow

similar fiscal reaction functions.– Poolability test: Testing whether estimated slope coefficient not

significantly different between countries. H0 cannot be rejected.

Choice of vintage: Vintage t|t rather than t|t-1 data fits better for real time model: Adjustment to fiscal policy during the year (see e.g. Kalckreuth and Wolff, 2007).

Application of Blundell and Bond estimation approach: provides consistent estimates of dynamic panel models, when autoregressive parameter is large.

Output gap instrumented with its own lags to account for possible endogeneity.



Results: Baseline Case

(A) Ex post CAPBgap is not significant: Discretionary policy is acyclical

(B) Ex-post data CAPB plus z and vz and gap jointly significant: Discretionary policy is counter-cyclical

(C) Real time CAPB (a la Cimadomo)gap is significant: Discretionary policy is counter-cyclical

(D) Real time PB (our model)Discretionary policy is counter-cyclicalAutomatic policy is counter cyclical: 0.8 - 0.56 = 0.24.

Smaller compared to previous findings.



Results: Extra Control Variables

Coefficients measuring discrectionary and automatic fiscal policy robust to specification of control variables.

Significant Maastricht-effect: governments made addit. effort to tighten fiscal policy in run-up to EMU, if deficit > 3%.

In an election years, fiscal policy is around 0.35 percentage points looser.



Conclusions

Real time measurement error of output gap complicates fiscal policy

Ex post, fiscal policy looks acyclical, but in real time it looks countercyclical– Policymakers are misinformed rather than malintentioned– Remedies based on malintentioned diagnosis are unlikely

to work Problem doesn’t show up in real time, so watchdog may

not spot it

New methodology suggests automatic stabilisers weaker than commonly thought (0.24 rather than 0.35-0.50)– Traditional methodology may wrongly attribute some

counter-cyclical discretionary policy to automatic side

Documents

Disclaimer: The views expressed are those of the author and not necessarily those of DNB Did fiscal policymakers know what they were doing? Re-assessing