The Structural Balance - Where Facts become blurred
Posted on August 05, 2015 by Tom McDonnell
Ireland is expected to successfully exit the corrective arm of the Stability and Growth Pact (SGP) at the end of 2015. From 2016 onwards Irish budgetary policy will be subject to the requirements of the preventive arm of the SGP as well as being subject to national budgetary rules. The preventive arm of the SGP is assessed under two pillars.
One of these pillars is the structural balance rule. Any country not at its Medium-Term Budgetary Objective (MTO) is required to achieve a minimum improvement in the structural balance of more than 0.5 percentage points per annum.
However, the structural balance is unlike the general government balance in that it cannot be observed directly. Instead, calculation of the structural balance is based on the estimated gap between the economy’s ‘potential output’ and the actual level of output. Potential output is itself estimated with reference to a number of factors such as the spare capacity in an economy, the level of technology in a country, the total stock of capital and the potential supply of labour. Different assumptions for potential employment and for other variables lead to different estimates for the structural balance.
The difference between actual and potential GDP is referred to as the ‘output gap’. The value of the output gap is negative when potential GDP exceeds actual GDP. The estimated output gap is used to derive a value for the cyclical component of the budget deficit with the residual component identified as ‘structural’. Government policy and action can influence national innovative capacity, the investment rate and the potential supply of labour and in so doing influence potential output. This means that potential output can itself be changed and this creates further complications when trying to estimate the trajectory of the structural balance in future years.
The Fiscal Responsibility Act 2012 says that the lower limit of the MTO shall be an annual structural balance of the general government of minus 0.5% of gross domestic product at market prices, except where the debt to GDP ratio is significantly below 60%, in which case the lower limit is reduced to minus 1%. A balanced budget in structural terms is defined as a balanced budget after adjusting for the cyclical position of the economy and is calculated net of one-off factors such as asset sales and bank bailouts. The structural balance will remain constant if expenditure grows in line with potential GDP; will improve if expenditure grows below potential GDP, and will deteriorate if expenditure grows faster than potential GDP.
The Commission estimated structural balances of EU member states appear within the NERI’s Quarterly Economic Facts as indicator 6.3b. At minus 4.1% of potential output Ireland is estimated to have had the second worst structural deficit in the entire EU in 2014. Six countries, one of which is Greece, are estimated to have had structural surpluses in 2014.
Ireland’s large structural deficit suggests relatively tight budgets for the next few years and limited scope for increasing public spending or cutting taxes.
However, estimates of the output gap are uncertain and usually subject to substantial revision even years after the fact. There is a notable lack of consensus regarding the current size and direction of the Irish economy’s output gap. The OECD estimate that, given the scale of underemployed resources, the economy will be operating at 1.9% below its potential in 2015 and 0.7% below its potential in 2016, with a structural deficit of 1.7% of potential output in 2016. The IMF estimates the economy will be operating below its potential until 2017 with a structural deficit of 2.0% in 2015 and 1.4% in 2016.
On the other hand the European Commission estimate the economy is already operating close to its post-recession potential and that despite high rates of unemployment the economy was actually marginally overheating as early as 2014. The Commission estimates the economy will be operating 0.9% above potential in 2015 and 0.8% above potential in 2016, with a structural deficit of 3.3% in 2016. The government’s own projections are based on the Commission mandated harmonised methodology. These projections suggest there will be a positive output gap by the end of 2015, with a structural deficit of 2.3% in 2016.
The economy’s still high unemployment rate, combined with a large current account surplus and the evident lack of domestic inflationary pressure in the economy, cumulatively suggests that actual output is somewhat below potential output in 2015. If so, it means the 2015 structural balance measured in potential output terms is somewhat better than the 2015 budget balance measured in GDP terms. The 2015 budget balance will be close to 2% of GDP. Thus an estimate of the structural deficit in the public finances of less than 1.5% of potential GDP in 2016 appears reasonable assuming a budgetary package along the lines described in the Spring Economic Statement.