Abstract
Eurozone members are supposedly constrained by the fiscal caps of the Stability and Growth Pact. Yet ever since the birth of the euro, members have postponed painful adjustment. Wishful thinking has played an important role in this failure. We find that governments’ forecasts are biased in the optimistic direction, especially during booms. Eurozone governments are especially over-optimistic when the budget deficit is over the 3 % of GDP ceiling at the time the forecasts are made. Those exceeding this cap systematically but falsely forecast a rapid future improvement. The new fiscal compact among the euro countries is supposed to make budget rules more binding by putting them into laws and constitutions at the national level. But biased forecasts can defeat budget rules. What is the record in Europe with national rules? The bias is less among eurozone countries that have adopted certain rules at the national level, particularly creating an independent fiscal institution that provides independent forecasts.
Highlights
Fiscal rules are increasingly proposed as a means of reining in excessive budget deficits
Euro area forecast errors are comparable to non-euro area forecasts much of the time, but when the limits set out in the EDP are breached euro members have very large over-optimistic forecast errors. These findings support the idea that when faced with fiscal rules like the Stability and Growth Pact (SGP), countries find it tempting to adjust their forecasts to meet the criteria, rather than taking the painful actions needed to meet the criteria in reality
Before turning to the examination of the impact of different types of fiscal rules on budget balance forecast errors, we briefly describe the indices we use to measure the strength of national fiscal rules
Summary
Fiscal rules are increasingly proposed as a means of reining in excessive budget deficits. It is clear to all that the Stability and Growth Pact (SGP) has failed to keep budget deficits and debt levels of eurozone members within the limits specified: originally 3% of GDP and 60% of GDP, respectively. The goal of the compact is to strengthen fiscal rules among euro members, in particular by writing them into laws and constitutions at the national level. The bias toward optimism in fiscal forecasts among the 24 countries included in this study is 0.28% of GDP at the one-year horizon, 0.93% of GDP at the two-year horizon, and 1.90% at the three-year horizon. For the 17 European countries, the bias is even higher, despite the rules of the SGP (or perhaps because of them): 0.52% at the one-year horizon, 1.29% at the two-year horizon and 2.4% at the three-year horizon.. For the 17 European countries, the bias is even higher, despite the rules of the SGP (or perhaps because of them): 0.52% at the one-year horizon, 1.29% at the two-year horizon and 2.4% at the three-year horizon. An important component of the overoptimism in official forecasts of the budget deficit is over-optimism in official forecasts of GDP.
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