One of the ways Europe attempts to rein in budget deficits is by setting uniform fiscal rules with its Stability and Growth Pact.The idea is to hold every country avoid significant fiscal imbalances between countries. Deficits are not supposed to exceed 3 per cent each year.
Despite the good intentions of the pact, a recent NBER working paper from Jeffrey Frankel and Jesse Schreger finds that it might actually be counterproductive.
Their study finds that though Eurozone countries routinely break the 3 per cent barrier, they almost never forecast that they will in the future.
Basically, countries with excessively high deficits want to give the impression that they are dealing with the problem to avoid consequences from the EU. As a result, they overestimate their GDP, and predict that they will reduce budgets much more quickly than they do in reality.
From the paper:
…when Euro area countries are in violation of the EDP at the time a forecast is made, their one year forecasts are biased by over 1.5% of GDP more than non-euro violators of the EDP limit. At the two year horizon, the point estimate is over 2% of GDP.
Forecasts of GDP, spending, and revenue are used to determine policy. If a boom is projected to last indefinitely, as frequently happens, a country won’t save for a rainy day. If numbers are skewed to appear more positive, a country may not carry out the necessary deficit reduction.
These forecast issues are just one of the issues with Europe’s current structure that helped cause the current crisis.