Abstract
This paper discusses how the technical foundations of the EU’s fiscal rules constrain the fiscal space in EU countries in the context of the COVID-19 pandemic. We review the evidence on how estimates of potential output, which are at the heart of essential control indicators in EU fiscal surveillance, were revised in the ten years running up to the COVID-19 pandemic, and how these revisions affected the fiscal stance of EU countries. We provide first evidence for downward revisions in the European Commission’s potential output estimates against the background of the COVID-19 shock across the EU27 countries, and we assess the potential consequences in terms of fiscal space. According to our results, one additional percentage point in predicted losses of actual output is associated with a loss in potential output of about 0.6 percentage points. Given the importance of model-based estimates in the EU’s fiscal rules, avoiding pro-cyclical fiscal tightening will require that policymakers’ hands are not tied by overly pessimistic views on the development of potential output.
Highlights
This paper discusses how the technical foundations of the EU’s fiscal rules constrain the fiscal space in EU countries in the context of the COVID-19 pandemic
The correlation is not perfect, but one additional percentage point in predicted losses of actual output is associated with a loss in potential output of about 0.6 percentage points, and the simple bivariate regression explains more than 30% of the cross-country variation in estimated potential output losses
This paper has documented downward revisions in potential output by the European Commission across the EU27 countries, and these downward revisions tend to be stronger in those countries that are forecast to suffer a larger decline in economic activity relative to the pre-COVID-19 levels
Summary
This paper discusses how the technical foundations of the EU’s fiscal rules constrain the fiscal space in EU countries in the context of the COVID-19 pandemic. We use the Commission’s model-based potential output estimates produced back in 2007 (before the start of the financial and economic crisis) and extend them by using a constant growth trend for the years 2010-2019.2 By using this simple trend extrapolation, we find a large negative output gap (the difference between actual output and potential output) of -16.9% of GDP for the year 2019, which starkly contrasts with the official Commission estimate of -0.2%. Whereas the European Commission’s official potential output estimate in Autumn 2019 (i.e. before the start of the COVID-19 pandemic) bends down to meet actual GDP, the trend extrapolation shows a large and growing negative output gap, indicating underutilisation of economic resources (see Figure 4). In the case of a small output gap, the fiscal
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