A recent background report from the Finnish Economic Policy Council shows that forecasts of Finland’s economic growth prospects have been over-optimistic, especially in times of crisis. Forecasts for Finland’s key trading partners, Sweden and Germany, have exhibited much smaller forecasting errors.
Finland is committed to the European Union’s common fiscal rules, which are expressed in structural terms using potential output and output gaps. The challenge is that both potential output and output gaps are unobservable measures that need to be estimated, and there is no single correct way of doing this.
In the council’s background report, doctoral researcher Adam Rybarczyk compares estimates from the European Commission, the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) for Finland, Sweden and Germany over the past 20 years. He examines how the accuracy of the estimates improves through revisions as the underlying time series are updated with new data vintages.
Real-time estimates of Finland’s economic prospects have been too optimistic
The report shows that real-time estimates of the potential output of the Finnish economy have been too high, especially during periods of sharp cyclical changes. The overestimates mainly result from over optimistic forecasts of total factor productivity growth in Finland. For Germany and Sweden, the errors in the productivity forecasts have been much smaller.
The report also demonstrates that the real-time estimates of the output gap in the Finnish economy have been too low and have changed considerably, as the time series used in the estimates have been updated. The revisions to the estimates for Sweden and Germany have been considerably smaller.
“According to the study, real-time estimates of Finland’s potential output have been too high on average, and estimates of the output gap, therefore, too low. The accuracy of the estimates does improve over time. However, since the estimates are used when deciding on fiscal policy – spending and taxation – their accuracy in real time is important,” says Adam Rybarczyk.
Overly optimistic estimates lead to loose fiscal policy
The study looked at the estimates produced by the Commission, the IMF and the OECD for Finland, Sweden and Germany, and their revisions. For all three countries, the Commission produced the most accurate real-time estimates. The accuracy of the Commission’s estimates for Finland also improves faster after the initial publication than the accuracy of the IMF or OECD estimates. In a cross-country comparison, the accuracy of the Commission’s real-time estimates for Germany and Sweden was significantly better than the accuracy of the Finnish estimates and the revisions to the estimates were smaller.
The study finds that the estimates of Finland’s output gap produced by all institutions show signs of pro-cyclicality, meaning that the economic situation at the time of the assessment has influenced the estimates. In particular, the sharp economic upturn preceding the 2008-2009 economic crisis affected the estimates and estimates of the output gap from this period have since been revised upwards.
During cyclical fluctuations, especially at turning points, it is generally difficult to assess the economic situation clearly in real time. However, overly optimistic forecasts of potential output can also be used to explain deviations from fiscal rules. A higher forecast of the level of potential output can be used to justify more public spending than is sustainable.
“In Finland, the scale of the economic boom before the financial crisis was underestimated. This was due to an over-optimistic view of how aggregate productivity would grow. Due to the delay with which estimates of potential output are updated, estimates of the output gap for 2010-2011 also required upward revisions. The challenge is that low real-time estimates of the output gap can lead to a fiscal stance that is too loose,” says Adam Rybarczyk.
The study also uses the EUCAM software used by the Commission to calculate estimates of potential output and the output gap for Finland, Sweden and Germany with the European Commission’s estimation method, using different data vintages. This allows for the assessment of how the different production factors (total factor productivity, labour and capital) affect the estimates through the production function. The study includes recommendations on how to achieve more accurate forecasts by changing the parameterization of the factors of production.
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Further information: Structural balance
The shared fiscal rules of the European Union are expressed in structural terms using
potential output and output gaps:
- Potential output can be thought of as a budgetary constraint on public spending in
the longer term. It reflects the long-term sustainable level of output in the economy,
i.e., the highest level of output that can be maintained without accelerating inflation.
- The output gap reflects the cyclical position of the economy and determines the
direction of fiscal policy. It is the difference between actual and potential output.
- If the output gap is positive, the economy is at overcapacity, which puts pressure on wage and price increases, and inflation accelerates.
- If the output gap is negative, economic resources are underutilized and inflation tends to slow down. In an economic downturn of this kind, efforts are made to stimulate the economy and avoid spending cuts.
Structural terms are independent of the business cycles and describe the part of the government deficit that is due to permanent structural factors. If the observed deficit is caused by a temporary downturn, then there is no need to worry about the sustainability of public finances.
The volume of many sources of government revenue and targets of expenditure change with the business cycle without any specific decisions being taken. For example, in an upturn, government tax revenues increase, and, in a downturn, the amount of unemployment benefits paid increases accordingly. Due to these automatic stabilizers, the observed residual does not necessarily reflect the state of decision-based fiscal policy.
In order to assess the impact of fiscal policy on the government balance, the nominal government balance has to be adjusted by removing the effect of the business cycles, i.e., the output gap. This is called the cyclically adjusted balance. The structural balance is obtained by removing one-off and temporary revenues and expenditures from the cyclically adjusted balance.