Twenty five countries in Europe are expected to pass the Fiscal Compact, thus committing themselves to via an international treaty to having a maximum cyclically adjusted budget balance of 0.5 percent of GDP.
There are two steps to calculating cyclically adjusted budget deficits. The first to to figure out the gap between output and its “potential” level; the second is to estimate the sensitivity of the deficit to movements in the output gap. Neither step is trivial and sensible economists can arrive at quite different answers.
There has been an interesting debate in the US blogosphere over the past few weeks about calculating output gaps. See, for instance, this post from Tim Duy. There hasn’t been much debate in Europe about this issue (partly because, as the folks from Bruegel put it, Europeans can’t blog!) but if anything the issues are more complex given the variety of different structural issues facing European economies. Certainly, if past history is anything to go by, there is no reason to expect cyclical adjustment calculations to be anything other than controversial.
For example, see below for the Commission’s estimated output gap for Ireland in 2007 versus their latest series (data source here). In 2007, the Commission estimated that Ireland’s output was 0.2 percent below its potential level. Now, with the benefit of hindsight, the Commission estimates that Ireland’s output was 3.7 percent above its potential level in 2007.
Interestingly, the Commission are projecting the Irish output gap to have disappeared by next year, despite an unemployment rate of 13.6 percent. We have yet to find out which body will be charged with calculating Ireland’s cyclically adjusted deficit by the fiscal responsibility bill required to implement the treaty. However, I doubt if they will agree with this particular aspect of the Commission’s analysis.