Improving fiscal policy in the EU: the case for independent forecasts

TLDR: In this article, the authors point out that official forecasts of output dynamics are crucial to the assessment of cyclically adjusted budget balances, and provide evidence that in some euro-area countries biased forecasts have played a thus far neglected role in generating excessive deficits.

Abstract: ARE OFFICIAL OUTPUT FORECASTS BIASED? We point out that official forecasts of output dynamics are crucial to the assessment of cyclically adjusted budget balances, and provide evidence that in some euro-area countries biased forecasts have played a thus far neglected role in generating excessive deficits. We suggest that the forecast bias may be politically motivated, and that forecasts produced by an independent authority would be better than in-house Ministry of Finance forecasts for the purpose of monitoring budget formation and budget outcomes. — Lars Jonung and Martin Larch

Figures

Table 4

Table 3

Table 5

Table 2

Table 1

Full text

EUROPEAN
ECONOMY
EUROPEAN COMMISSION
DIRECTORATE-GENERAL FOR ECONOMIC
AND FINANCIAL AFFAIRS
ECONOMIC PAPERS
ISSN 1725-3187
http://europa.eu.int/comm/economy_finance
N° 210 July 2004
Improving fiscal policy in the EU:
the case for independent forecasts
by
Lars Jonung and Martin Larch

Economic Papers are written by the Staff of the Directorate-General for
Economic and Financial Affairs, or by experts working in association with them.
The "Papers" are intended to increase awareness of the technical work being done
by the staff and to seek comments and suggestions for further analyses. Views
expressed represent exclusively the positions of the author and do not necessarily
correspond to those of the European Commission. Comments and enquiries
should be addressed to the:
European Commission
Directorate-General for Economic and Financial Affairs
Publications
BU1 - -1/180
B - 1049 Brussels, Belgium
ECFIN/4971/04-EN
ISBN
92-894-7876-4
KC-AI-04-210-EN-C
©European Communities, 2004

IMPROVING FISCAL POLICY IN THE EU: THE CASE FOR INDEPENDENT
FORECASTS
Lars Jonung and Martin Larch
July 2004
Abstract: The evidence from several euro-area countries demonstrates the existence of a
forecast bias in the budgetary process, which negatively affects fiscal performance. To
remedy this bias, we suggest that forecasting should be assigned to an authority
independent from the ministry of finance and the government, with the task of producing
unbiased projections of growth and other variables crucial for the budgetary process. The
ministry of finance should then be obliged to adopt these forecasts in the preparation of
the official budget, thereby revealing ex ante its true preference concerning the size of
the budget balance. The usefulness of our proposal is corroborated by the experience of a
small number of EU Member States which already apply similar arrangements.
The forecasting authority should be designed in such a way as to give it strong incentives
to produce unbiased forecasts. This could most easily be accomplished by giving it a
high degree of independence, similar to that of the national central banks in the ECB-
system and of the central banks in countries such as New Zealand, Sweden and the
United Kingdom. The forecasting authority – like a modern central bank – should be
protected by legislation from domestic political pressure. We also set our
recommendation in a wider context by comparing it to recent proposals for fiscal policy
reform in the EU. Regardless of what other option for fiscal reform is pursued, our
proposal would serve as a constructive complement.
JEL classification: E6, F02 and H60.
Comments invited to Lars.Jonung@cec.eu.int and Martin.Larch@cec.eu.int
Please note: The views and opinions expressed here are those of the authors. They do not
represent the views of DG ECFIN.

2
Table of contents
1. INTRODUCTION....................................................................................................... 3
2. FORECAST BIASES IN THE PRESENT FISCAL POLICY MAKING
PROCESS.................................................................................................................... 5
2.1. Forecast errors and the fiscal stance in theory .................................................. 6
2.2. Do forecast errors matter in practice? ............................................................... 8
2.3. Are forecasts biased?.......................................................................................10
3. THE CASE FOR INDEPENDENT FISCAL FORECASTS .................................... 11
3.1. Why is there a forecast bias?........................................................................... 11
3.2. An independent forecasting authority ............................................................. 12
3.3. Would an independent forecasting authority make a difference within
the EU? ........................................................................................................... 14
4. COMPARISONS WITH OTHER PROPOSALS FOR FISCAL POLICY
REFORM...................................................................................................................14
4.1. Reforming the Stability and Growth Pact: A brief overview.......................... 14
4.2. Where does the independent forecasting authority fit in?............................... 16
5. SUMMARY .............................................................................................................. 16

3
IMPROVING FISCAL POLICY IN THE EU: THE CASE FOR INDEPENDENT
FORECASTS
1. INTRODUCTION
1
How should the fiscal policy process of the Member States of the EU be designed? This
question is presently the subject of lively discussion among policy-makers and
economists alike. The debate has been fuelled by the recent controversy concerning the
budgetary positions of Germany and France, which culminated in the ECOFIN decision
of November 25, 2003. It has set off a flood of comments and proposals for re-
interpreting, revising or modifying the Stability and Growth Pact (SGP), the legal
framework for fiscal policy-making within the EU.
2
However, the debate goes back much further in time. Ever since the decision to create a
European monetary union, economists have debated the proper role and framework for
fiscal policy-making within a monetary union where monetary policy is centralized in
one institution while fiscal policy-making is decentralized to the governments of the
Member States (though remaining subject to a common legal framework concerning
criteria for domestic debt and deficits). This is a historically unique situation. Never
before has a group of independent nation states handed over their monetary sovereignty
to a central monetary authority, while maintaining fiscal sovereignty – that is the right to
tax and spend – within the nation-state.
3
In short, the fundamental question is: How and
to what extent – if any – should fiscal policies be co-ordinated across the euro area?
Many of the proposals for reform advanced by economists are inspired by the rule-bound
strategy for monetary policy, which currently represents the mainstream stabilization
policy paradigm. It is embedded in the design of the ECB-system and in that of other
independent central banks. According to the prevailing consensus within the economics
profession, central banks should have a high degree of independence from the political
system and be assigned an explicit target for inflation. In this way, the incentives for
short-run political manipulations of the economy are minimized, while monetary policy-
makers can focus on long-run objectives concerning price stability.
This policy framework is commonly regarded as successful where it is presently applied,
such as Canada, New Zealand, Sweden, United Kingdom, and in the euro area. In short,
monetary policy has been taken out of the political sphere – it has been depoliticized –
and given to independent experts and bureaucrats to administer.
To what extent could this approach be carried over to fiscal policy-making? Can and
should fiscal policy be made as rules-based as monetary policy at the expense of fiscal
discretion? Several recommendations in this direction have recently been put forward.
1
This paper has benefited from comments by Michael Artis, Robert Boije, Elena Flores, Heikki Oksanen
and Jan Schmidt. Editorial help by Sophie Bland is gratefully acknowledged. Any remaining errors are
the sole responsibility of the authors. The views and opinions expressed here are those of the authors.
They do not represent the views of DG ECFIN.
2
See for example Fatás et al. (2003) and Gros et al. (2004).
3
On this point see Jonung (2002).

Frequently asked questions

Q1. What are the contributions mentioned in the paper "Improving fiscal policy in the eu: the case for independent forecasts" ?

To remedy this bias, the authors suggest that forecasting should be assigned to an authority independent from the ministry of finance and the government, with the task of producing unbiased projections of growth and other variables crucial for the budgetary process. The forecasting authority should be designed in such a way as to give it strong incentives to produce unbiased forecasts. The forecasting authority – like a modern central bank – should be protected by legislation from domestic political pressure. The views and opinions expressed here are those of the authors. 

Q2. What is the main advantage of an independent forecasting authority over current arrangements?

Another advantage of an independent forecasting authority is that it will strengthen the working of a democratic society by making the budgetary process more transparent, thus raising the quality of public debate and ensuring the accountability of fiscal policy. 

Q3. What is the standard method for reform propagated by economists?

the standard method for reform propagated by economists is to find better institutions than the existing ones, more precisely, to modify the institutional framework so as to diminish the problems created by the incentive structures facing politicians. 

Q4. Why is it safe to assume that contemporaneous corrections for growth surprises will be limited?

In particular, on account of the inertia and complexity generally found in the fiscal policy-making processes, it is safe to assume that contemporaneous corrections for growth surprises will generally be limited. 

Q5. Why are the test statistics poor when running the regression for each country?

Due to the small number of observations (18 per country), test statistics are relatively poor when running the regression for each country individually. 

Q6. What would be the main advantages of an independent forecasting authority over current arrangements?

In particular, the independent forecasting authority would significantly restrict the possibility of the fiscal authorities to systematically overestimate growth, and hence future revenues ex ante, and then to blame bad fiscal performance on other developments ex post. 

Q7. What is the main advantage of the proposed forecasting authority over current arrangements?

A major advantage of the proposed forecasting authority over current arrangements is that it will be easier to track its performance, as its forecasts are made public. 

Q8. What is the main argument for an independent forecasting authority?

regardless of the framework one wants to build for the budgetary process to ensure specific objectives, unbiased forecasts – presumably produced by an independent authority – will always represent an improvement either in terms of fiscal performance or at least in terms of the accountability of discretionary fiscal policy. 

Q9. How is the accuracy of official forecasts checked?

Following the by now conventional approach pioneered by Theil (1966), the accuracy of official forecasts is checked by regressing the prediction errors of potential output growth on a constant α),(~1 σεεα oNY Y Y Y E ttP t P t P t P t t += ∆ − ∆ −and testing the null hypothesis of unbiasedness 0:0 =αH . 

Q10. What is the way to test the practical bearing of forecast errors on the fiscal stance?

A straightforward way to test the practical bearing of forecast errors on the fiscal stance is to include them as a variable in regressions examining the empirical relevance of fiscal rules as in Bohn (1998), Ballabriga and Martinez-Mongay (2002) or Gali and Perotti (2002). 

Q11. What is the main reason why von Hagen et al. (2004) conclude that the form?

On the basis of an empirical analysis, von Hagen et al. (2004) conclude that the form of fiscal governance is an important factor explaining the bias in GDP growth forecasts. 

Q12. Why is it important to leave the task of producing economic forecast to an independent authority?

It can be justified on the grounds that producing economic forecast is not the ‘core business’ of governments and, since it requires technical expertise, it may easily be left to non-political experts.