This study presents a compact model that allows a stylised, yet dynamic reasoning on the main macrofiscal aggregates that are relevant for setting budgetary paths compatible with the structural budget balance requirements of the preventive arm of the Stability and Growth Pact. Some lessons on the conduct of fiscal policy in a reference framework in structural terms can be learned from the simulations provided for illustrative purposes. These simulations show in particular that – under certain conditions relating to the degree to which the budgetary adjustments have a permanent effect on the economic activity and thus on potential GDP – when the feedback effects of adjustments on the underlying macroeconomic environment are left out of consideration, this can be detrimental to the credibility of the considered structural paths.
This study presents a compact model that allows a stylised, yet dynamic, reasoning on the main macrofiscal aggregates that are relevant for setting budgetary paths compatible with the requirements of the preventive arm of the Stability and Growth Pact. This preventive arm requires notably that minimum annual improvements in the structural balance have to be made and a structural medium-term objective has to be reached.
In this context, Belgium’s normal practice encompasses at least two stages. First, the FPB provides a macrofiscal framework at constant policy: the short-term forecasts (Economic Budget of September) or the medium-term projections (Economic Outlook of March). Subsequently, the government sets budgetary targets while taking into account the recommendations of the High Council of Finance and defines – where necessary – the appropriate adjustment measures. It then files Belgium’s draft budgetary plan (in October) or Belgium’s stability programme (in April) with the European authorities.
In this process, the feedback effects of the adjustment measures – or of the normative budgetary path – on the pre-established macroeconomic framework are rarely discussed. It is in fact this macroeconomic framework at constant policy that is presented to the European authorities together with the normative budgetary plans, which has been subject to recurrent criticism by the European Commission (EC) in its analyses of Belgium’s draft budgetary plans.
While the possible recessive effects of the fiscal adjustments are hardly ever discussed, their effects on potential GDP, the cyclical component of the deficit or the structural development in debt are never examined. Yet, if the budgetary targets are expressed in structural terms, these issues should be considered as relevant, as shown by the model described in the paper.
In this compact model, the public finance variables are limited to the primary balance, interest expenditure, the financing balance and the general debt of the government. Their developments are presented in nominal and structural terms. The interactions between public finance and macroeconomy are taken into account through three parameters or functions: a fiscal multiplier, a fiscal semi-elasticity and a hysteresis function containing a closure rule for the output gap. The model is calibrated in such a way to match the standard reactions of the FPB’s HERMES model and the European method for estimating potential GDP and the cyclical component.
The hysteresis function models the degree to which the budgetary adjustments have a permanent effect on economic activity. Without hysteresis, the effects on economic activity are temporary: potential GDP is not affected, and it is through a reaction of the actual growth that the output gap stemming from the possible recessive effects of the fiscal adjustment is closed in the medium term. With hysteresis, the effects of the fiscal adjustment are – at least partly – permanent: the potential GDP level is affected and, in the medium term, potential growth helps close the output gap partly or entirely. Illustrative simulations include different assumptions on the effects on potential GDP and provide some lessons on the conduct of fiscal policy in a reference framework in structural terms.
If the fiscal adjustment has no permanent effects on economic activity, a fiscal policy that does not take into account the feedback effects does not jeopardise its structural balance targets, in variation or in level. The nominal macroeconomic aggregates and the tax receipts of which they constitute their tax base will certainly be overestimated, but these feedback effects will all feed the cyclical component of the deficits, so that the structural aggregates will not be impacted. If the budgetary adjustment has permanent effects on economic activity, potential GDP is affected, not only in the medium term, but potentially also in the recent past as a result of the method used to set up this variable (which cannot be observed or compiled). In that case, the estimate of the cyclical component is modified, not only for the year in which the adjustment takes place and the near future, but also for the recent past.
Consequently, carrying out a fiscal adjustment entails a negative revision – in variation and in level – of the structural balance of the previous years. In a way, the adjustment measures taken by the Michel government deteriorate a posteriori the track record of the Di Rupo government. It also follows that it is easier to achieve short-term annual improvements in the structural balance than to achieve a medium-term structural balance target, expressed in level. On the one hand, and no matter the assumed degree of hysteresis, the effects of a fiscal adjustment on the annual variation in structural balance in the short term (i.e. the year in which the adjustment takes place) is always almost equal to the ex-ante amount of the adjustment. As a consequence, ignoring the feedback effects does not jeopardise a target of short-term annual improvement in the structural balance. This conclusion leads us to put into perspective the relevance of the EC criticism about not including the feedback effects of the adjustment measures on the macroeconomic framework in the draft budgetary plans.
On the other hand, the higher the degree of hysteresis, the larger the gap between the ex-ante amount of a budgetary adjustment achieved in the short term and its effects on the level of the structural balance in the medium term. To determine the ex-ante amount of the adjustment needed to achieve a mediumterm structural objective, a compensatory amount for the feedback effects has to be added to the deviation from the structural balance at constant policy. The higher the degree of hysteresis, the higher will be the amount.
Without this compensation, it is possible to be faced with a situation in which – despite complying with the objectives of annual improvements in the structural balance – the medium-term objective level remains out of reach (while, based on a static reasoning, one would expect the medium-term objective to be achieved with such annual improvements).
It also follows from the above that a methodological framework assuming a high degree of hysteresis would more likely lead to putting off the implementation of adjustment efforts if the objective is to achieve a structural balance at the end of a given time horizon. However, this only holds true in a context where interest rates are low. Moreover, the European rules prevent putting off these adjustments since they lay down an obligation to respect a minimum annual structural path and impose a pace of debt reduction.