Early Warning or Just Wise After the Event? The problem using

Cyclically Adjusted Budget Balances for Fiscal Surveillance

in Real Time

Montreal, October 2007

Andrew Hughes Hallett, George Mason UniversityRasmus Kattai, Bank of Estonia

John Lewis, De Nederlandsche Bank

The Dutch Experience

June 2004:Excessive Deficit Procedure initiated against NL for 2003 budget deficit figure

Was the fiscal slippage apparent earlier on from CAB data?

Cyclically Adjusted Budget Deficit: Economic Forecasts (European Commission)1996 1997 1998 1999 2000 2001 2002 2003 2004

Spring 2004 -0.9 -0.9 -1.5 -1 0.9 -2 -2.9 -2.4 -1.9Autumn 2002 -1.0 -0.9 -1.5 -0.9 -0.6 -1.2 -0.8 -0.5 -0.4

Autumn 2001 -1 -0.8 -1.3 -0.6 0.1 0.8 0.8 1.4

The Basic Problem

))(( * YYBB t

• We don’t know what the output gap is• We don’t know the final budget balance is until several years

after the event

• Estimating the CAB s years after the event we make the error:

Budget balanceCAB Output gap

Sensitivity Revision to Output gap

Revision to deficit ratio

Empirical Analysis

• Use the OECD’s figures from successive issues of economic outlook– December 1995-December 2005

• Actual budget deficit• Output gap• Cyclically adjusted budget deficit

• How much does the reported figure change across vintages– i.e. How much does the 2000 output gap figure change between

different issues of EO

• How many episodes of fiscal slippage- defined by ex post data- showed up in real time

• How accurate are real time CABs in picking up fiscal improvements?

• Are revisions systematically correlated with the state of public finances?

Data Revisions

Output Gap: RMSE at time t+s vs final figureDeficit Ratio (same measure)

Data Revisions: CAB

Early Warning?

• Measure of accuracy of real time figures• Fiscal Slippage: ex post CAB worsens by 1.5pp of GDP• If real time CAB slips by certain amount- trigger value-

then an alarm is sounded

Early Warning?

• How many fiscal slippages in the dataset does the real time data pick up?

Early Warning?

• 2nd definition: Change of CAB <-2.0pp over 2 years

Deficit Revisions or Cyclical Adjustment?

• Apply RT cyclical adjustment to ex post deficit data– Hypothetical CAB= Final Actual Deficit – Real time cyclical component

• Only source of discrepancy between hypothetical and final data is errors in real time cyclical adjustment

• Provides a crude way of isolating the impact of real time cyclical adjustment

• Eliminates most of the missed alarm problem…but doesn’t help the false alarm problem

Real time Data

Significant Improvement Test

• Countries in EDP (deficit of more than 3%) required to improve CAB by 0.5pp per annum

• Sample restricted to cases where d<-3

Are the Systematic Components to Revisions?

• Regress revision on the level and first difference of CAB– Over-optimistic when CAB

negative and/or falling

• Over optimistic when CAB falling (but not when rising)

• Revisions bigger when CAB negative and falling

Conclusions

• CABs are prone to large data revisions– Performance at picking up fiscal slippages is

poor– Difficult to distinguish between successful and

unsuccessful fiscal consolidations in real time– May require 2,3 even 4 years data to accurately

gauge picture

• Data revisions are systematically correlated with the state of public finances– Less reliable, more optimistic when public

finances are slipping– Most inaccurate when most needed