7.5
Implications and Conclusions
Monetary Union requires some form of fiscal pact, and although it is in the interests of all
to follow that pact, it is in the interests of each country to find special reasons why the
pact constraints may not apply to it in a particular year. The pact was designed to set
limits to borrowing, with penalties available for sustained breaches of the targets. These
penalties are supposed to take account of the impacts of the cycle on the deficit, but these
impacts are uncertain. We have investigated one representative estimator of the output
gap and derived its distribution, giving us a simple way of evaluating its uncertainty. This
in turn allows us to put uncertainty bounds around the budget deficit given an estimate of
the output gap on the deficit. We then discuss the uncertainties involved in the
relationship between the output gap and the deficit, showing that the source of shocks
impacts on the uncertainty surrounding a deficit projection.
All estimates of the output gap are uncertain, and ours is probably no worse than others.
Even those that are not revised are not known with certainty at the point when they are
made. There is a strong case for using production function based estimates of the output
gap, as in Denis et al. (2006), but these are more difficult to calculate than our measure,
and it is more complex, but not impossible, to evaluate the associated uncertainty. Even if
we know with certainty the parameters of the production function we still have to
estimate trend hours, trend productivity and the equilibrium level of employment. If these
are estimated using a filter, which is common, then it is possible to evaluate directly their
uncertainty and feed this into the gap. If they are the result of reduced form calculations,
then a more complicated process of looking at the error variance on the reduced form has
to be gone through.
It is our contention that the error bounds around any estimate of the output gap are wide.
Given these uncertainties it will always be possible to put bounds around the cyclically
adjusted deficit. We strongly advocate that this should be done by all official bodies
involved with the evaluation of deficits in Europe as well as by the scientific community.
It would be more prudent to accept that we are ignorant rather than argue about gaps;
hence we should evaluate budget deficits in probabilistic terms. This would involve
asking whether a budget target is within the 95 per cent (or 64 per cent) bounds around
the cyclically adjusted deficit. In undertaking this analysis it is also useful to discuss the
source of weak demand that has caused the output gap and then use an appropriate
coefficient (perhaps not 0.5) in the adjustment. In all cases humility over our ignorance
and strength about the obvious, such as the scale of recent deficits in France and
Germany, are important characteristics of sensible debate.
simple adjustment to our figures of this magnitude; hence we can say that the balance of probabilities
is that it has not been meeting its target over the last four years; e.g. see Kirby and Mitchell (2006).
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