Structural deficit must enter equation

The Fiscal Compact, an intergovernmental treaty that aims at putting the public finances of ratifying European Union members in order, has broadened the definition of the balanced budget by including the notion of the structural deficit. However, the structural or cyclically adjusted budget balance is not a target in the adjustment economic programs for Greece and other euro periphery states.

The outcome of the Italian elections, as well as Greece’s struggle to meet revenue targets in the midst of the worst economic slump in decades, should remind policymakers in core eurozone countries of the missing target variable.

Many analysts interpret the outcome of the Italian elections as a condemnation of the country’s political elite and, to some extent, as a vote against austerity. At the same time, the Greek government is trying to meet the fiscal targets agreed with its creditors by intensifying its efforts to bring in more revenues to state coffers despite the continuing decline of output, which is reminiscent of a depression.

The two countries find themselves at different stages, but both feel the impact of austerity, like others in the euro periphery.

Italy, which has a public debt-to-gross domestic product ratio close to 125 percent, recorded a primary budget surplus of around 2.9 percent of gross domestic product (GDP) last year, meaning revenues exceeded expenditures excluding interest payments by a wide margin. It also saw its current account deficit fall well below 1 percent of GDP after undertaking austerity measures to the tune of 3 percent of its output. It was thought – prior to the recent general elections – that it would take additional measures of a smaller scope this year.

Greece, whose public debt-to-GDP ratio is seen approaching 179 percent in 2013 from around 158 percent last year, saw the primary budget deficit shrink to an estimated 0.5-1.5 percent of GDP last year. It also saw the current account deficit drop sharply to 2.9 percent of GDP in 2012 from 9.9 percent in 2011 and expects it to break even this year.

The country has committed to implementing new austerity measures amounting to 11 billion euros, or more than 5 percent of GDP, in 2013 and to continue to do so next year and beyond.

In both cases, the general government budget deficit looks much better when adjusted to take into account the state of the economy. The so-called structural or cyclically adjusted budget deficit of Italy is projected at 0.1 percent of potential GDP in 2013 from 1.3 percent last year by the European Commission.

In contrast, the Italian unadjusted budget deficit is bigger, and estimated at 2 percent of GDP in 2013 from 2.8 percent last year. The difference is explained by the inferior performance of actual GDP compared to potential GDP, that is, the level of output that could be achieved with all the cylinders of the economy working at full capacity.

The difference between actual GDP and potential GDP is much bigger in the case of Greece due to the protracted recession, and this is reflected in the fiscal figures. The reported budget deficit is seen falling to about 4.5 percent of GDP in 2013 from 6.6 percent in 2012.

However, when adjusted to take into account the business cycle, Greece’s structural or cyclically adjusted budget points toward a surplus of 1.8 percent of potential GDP in 2013 from a deficit of just 0.8 percent last year. The surpluses become even bigger when one adjusts the primary budget balance for the state of the economy.

Consequently, we may conclude that the country’s large budget deficits are due to the poor state of the economy, which in turn is mainly due to an overdose in fiscal austerity and secondarily to other factors, i.e. loss of confidence etc.

It is indeed ironic that the definition of the balanced budget in the Fiscal Compact – which came into force on January 1, 2013 for a number of EU member-states, having completed ratification by then – takes into account both the general budget balance and the structural budget balance. Specifically, the treaty defines a balanced budget as an overall budget deficit of less than 3 percent of GDP and a structural deficit of less than 0.5 percent of GDP for the member-states whose public debt-to-GDP ratio is above 60 percent.

On the other hand, the structural budget balance is not a target variable in the bailout programs, like the general and the primary budget balances, even though it features in the Fiscal Compact.

This makes a big difference because the dose of austerity could have been smaller, perhaps much smaller, if the cyclically adjusted budget balance had been a target in the economic adjustment programs. A smaller dose could have perhaps helped break the vicious cycle of excessive austerity deepening the recession and leading to missed fiscal targets, necessitating more restrictive measures.

Of course, Italy and Spain are implementing their own economic programs and this is not an issue of immediate concern for them, unlike for Greece and Portugal. However, convincing the European Union authorities, and more specifically the German government, to include the structural budget balance as a target variable in bailout programs along the lines of the Fiscal Compact could have been to the benefit of everyone concerned.

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