Did fiscal policymakers know what they were doing? Re-assessing fiscal policy with real time data

1. Did fiscal policymakers know what they were doing?Re-assessing fiscal policy with real time data Kerstin Bernoth, De Nederlandsche Bank Andrew Hughes Hallett, De Nederlandsche Bank John Lewis, De Nederlandsche Bank CIRANO Workshop on Data Revision in Forecasting and Macroeconomic Policy Montreal, 10 October 2008

2. 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

3. Overview Paper makes two key contributions Compares fiscal policy reaction based on real time data with their ex post counterparts 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

4. 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

5. 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)

6. 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 Discretionary expenditures which respond to the real time output gap Do not change as estimates of output gap revised 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 Automatic expenditures which respond to the true (“ex post”) level of output Do change in response to the true output level

7. 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: “error” in real time potential output ex post output gap “error” in real time output gap =zt|t+s ex post primary balance

8. 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 “error” in real time output gap “error” in real time potential output

9. Discretionary vs Automatic Estimate the equation: Recall: (-) denote purely discretionary policy coefficient on output gap error captures discretionary policy (β-φ) denote purely automatic policy coefficient on ex post output gap captures sum of discretionary and automatic fiscal policy

10. 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

11. 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.

12. 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.

13. Results: Baseline Case (A) Ex post CAPB gap is not significant: Discretionary policy is acyclical (B) Ex-post data CAPB plus z and v z 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-cyclical Automatic policy is counter cyclical: 0.8 - 0.56 = 0.24.  Smaller compared to previous findings.

14. 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.

15. 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