Please welcome Orsola! She normally does research and writing for INET but thought our readers might be interested in understanding the implications of how Italy and 7 other countries just decided to push the European Commission to change their budget formula to be less stringent. This request comes against a backdrop of more and more economists, including, belatedly, Fed chairman Janet Yellen, acknowledging the need for more fiscal spending. Needless to say, it’s another demonstration case of how rule by technocrats has this funny way of riding roughshod over popular interests, in this case, by the use of models that falsely limit policy choices.
By Orsola Costantini, Senior Economist, Institute for New Economic Thinking
With the upcoming round of budgetary recommendations by the EU Commission set for May, the debate on how those harsh fiscal constraints are determined fires up again.
Eight countries, including Italy and Spain, sent an open letter to the Commission, asking for a redefinition in a more growth-friendly fashion of the formula used to estimate the output gap, that is the difference between current output and the economies’ potential. Depending on how far our economies stand from some previously defined optimal output condition, governments are allowed only certain types and amounts of deficit spending.
Hence, as the Italian finance minister Pier Carlo Padoan has long pointed out, the outcome in terms of fiscal room depends greatly on how the cycle and potential output are defined – which ultimately relies on considerations about what type of measures impact the most on the economy’s performance. But despite the noise around this letter, in fact the countries’ requests would imply only a slight re-orientation of the economic interests for which the Commission’s formula accounts and not a reconsideration of how obscure statistical tools regulate crucial policy decisions for the life and wellbeing of the EU citizens.
Just as debates arose in the early 2000s that led to the first reform of the Stability and Growth Pact which introduced the estimated budget constraints, this nmulti-country request for modest budgetary relief points up the degree to which the call for austerity reflects often shared elite convictions, rather than representing simply an imposition of one country on the others (for example: Germany) or dictates of technocrats. It also proves that most countries are not quite ready to give up a precious disciplinary tool to implement controversial reforms by blaming Brussels. In other words, they show no intention of dismissing the technocratic veil altogether and undertake responsibility for supporting selected social claims (and not others).
This is no news: The capacity of the fateful and long-lived estimate of structural budget to accommodate and justify, when needed and desirable, the implementation of different policy measures seems to be its reason for being. The latter are strictly connected with the awareness acquired over the thirties and forties that the composition of the fiscal action can be a crucial element of political mediation that defines the state-market relationship. Along with this awareness came the discovery that rigid compliance with estimated budget constraints can allow and even enable a great deal of flexibility toward vested economic interests.
Indeed, across time and schools of thought, potential output has been defined very differently, either as a target of the fiscal action or as a natural optimum to which the economy will tend to move all on its own. According to the former school of thought, a structural deficit results from too small a fiscal expansion, in the second from too small a contraction (for a full discussion of the history of the estimate see my paper).
The current formulation goes back to the consensus version reached in the 1980s, when the structural budget turned from a tool conceived to support full employment policies into a surveillance instrument for budgetary reduction. The method used by most governmental and international institutions including the European Commission is called the the production function method.
This formulation is based on the idea that economic growth is supply driven and relies heavily on univariate statistical filters. These all produce ex-post averages of the actual series that closely track the latter (Palumbo, 2013), as perfectly illustrated by a near 20% structural unemployment in the case of Spain (for a discussion of the Non Accelerating Inflation Rate of Unemployment and its implications for the EU policies, see this recent post by Antonella Stirati). As a result of this method, not only does potential output turn out to be the normal output, but the definition of this normal condition becomes one that ex-post justifies the performance of the economy, giving a near free pass to the effects of contractionary fiscal policy itself.
But most importantly, the production function method permits explicit consideration of the assumed effects on output of institutional and supply-side measures such as the degree of labour protection, market structure, pension reforms and social incentives, political – even electoral – reforms etc… Only in the face of those can governments obtain room for fiscal action.
As a result of these methods, as Alain Parguez says, we always are in full employment by decree, regardless of what the actual figures show. Moreover, specific fiscal actions, as well as institutional reforms, can be presented as the only way to increase the economies’ potential and thus succeed in the public debates.
This poses ever more urgently the issue of democratic control over economic policies that have immense social and political repercussions that are not adequately represented in official narratives nor in the technical models that the institutions use.
Such issue is however nowhere to be found in the current official debates. The suggested solution, if it ever succeeds, would hardly go in the direction of an emancipation of the discourse on fiscal policy from pseudo-technocratic dictat, that would instead imply the admission that the economic measures of the governments can serve any political priority one community decides to take on.
Palumbo, A. (2013): Potential Output and Demand-Led Growth, in: Levrero, E.S., Palumbo, A., Stirati, A. (eds.), Sraffa and the Reconstruction of Economic Theory, London: Palgrave Macmillan, 92-119