Getting measures of fiscal stance right for the new SGP

The recent revision of the Stability and Growth Pact (SGP) has confirmed the 3% deficit/GDP ratio as the pillar of the excessive deficits procedure for EMU member countries. Research on its implications for fiscal discipline and macroeconomic stabilization involves empirical matters. In particular, this paper presents an econometric estimate and simulations of a macroeconomic model of Italy and Germany aimed at addressing three issues. First, monetary and fiscal rules interactions are explicitly modelled and examined in a dynamic setting. Second, consistently with common perception and the new formulation of the SGP, the model is specified so as to capture cycles in terms of gaps in growth rates rather than in levels of GDP. Third, budgetary components are examined as separate fiscal rules, which allows us to track the reaction of the fiscal stance to growth shocks and suggest more accurate assessment of fiscal stances. The paper is organized as follows. In section 2 we introduce a macroeconomic model with monetary and fiscal policy rules suitable to econometric estimation. The model includes aggregate demand and supply for GDP and the inflation rate, a Taylor rule for the nominal interest rate and two fiscal rules for primary expenditure and total tax revenue. Consequently, we have a system of linear dynamic equations whereby we can study the evolution of the endogenous variables over the cycle in terms of rates of deviation from their balanced or target growth paths. Section 3 reports on the econometric results for Italy and Germany with yearly data from 1962 to 2004. We have chosen these two countries not only because they are major euro-economies, but especially because they differ markedly as to their monetary and fiscal history. Hence we expected that their comparison might deliver rich information on the issue of fiscal-monetary interactions, and econometric results do lend support to this presumption. Section 4 presents simulations of a temporary negative shock to the GDP growth rate in the two economies based on the respective estimated models. Simulations concern the five endogenous variables as well as two additional variables derived from the previous ones, namely the primary and the total budget. The system yields the sequence of variations of the variables until a new steady-state is reached and conveys information on the different dynamics of the various budget components over the cycle. From these simulated data, we can also examine the evolution of the deficit/GDP ratio shedding light on the much debated question of the actual control of governments on its cyclical behaviour. To conclude, in this paper we have sought to reframe the matter of the role of fiscal policy in the macroeconomic process in view of the implementation of fiscal rules within a consistent macroeconomic model whereby the cyclical dynamics of GDP, inflation, monetary and fiscal variables are jointly determined. We have shown that attempts at measuring the cyclical components of fiscal variables by means of estimated elasticities to some measure of the business cycle are undermined by several pitfalls. We have once again confirmed that the long-standing scepticisms and criticisms about the choice of the total deficit/GDP ratio as the pillar of the SGP rules are not groundless. Our simulations have highlighted how the sensitivity of such an indicator to the business cycle and to monetary policy may seriously mislead the assessment of the actual fiscal stance of a government. What is more important, we have shown that negative strings of growth gaps, even though triggered by temporary shocks, determine permanent output losses to which correspond permanent primary deficits, not reabsorbed by mere return to “normal” growth.