early warning or just wise after the event? the problem of using cyclically adjusted budget deficits...

Early Warning or Just Wise After the Event?

The Problem of Using Cyclically Adjusted Budget Deficits for

Fiscal Surveillance in Real Time

Andrew Hughes Hallett, George Mason UniversityJohn Lewis, De Nederlandsche Bank

Rasmus Kattai, Bank of Estonia

Estonian Economic Association Annual ConferencePärnu, 12 January 2007

Disclaimer: The views expressed are those of the authors and not necessarily those of the institutions to which they are affiliated

John LewisEconomics and Research DivisionDe Nederlandsche Bank

Early Warning or Wise After the Event?Estonian Economic Association

12 January 2007

Introduction

Output gap = 0

Revenues Expenditures

Economic c ycle



12 January 2007

The Dutch Experience

June 2004:Excessive Deficit Procedure initiated against NL for 2003 budget deficit figure

Was the fiscal slippage apparent earlier on from CAB data?

Cyclically Adjusted Budget Deficit: Economic Forecasts (European Commission)1996 1997 1998 1999 2000 2001 2002 2003 2004

Spring 2004 -0.9 -0.9 -1.5 -1 0.9 -2 -2.9 -2.4 -1.9Autumn 2002 -1.0 -0.9 -1.5 -0.9 -0.6 -1.2 -0.8 -0.5 -0.4Autumn 2001 -1 -0.8 -1.3 -0.6 0.1 0.8 0.8 1.4



12 January 2007

Overview of the Paper

• A simple model of fiscal surveillance

• Describing the real time dataset

• How Robust are CAB estimates over time?

• Effectiveness of CABs as an early warning indicator



12 January 2007

The Basic Problem

))(( * YYBB t

• We don´t know what the output gap is• We don’t know the final budget balance is until several years

after the event

• Estimating the CAB s years after the event we make the error:

Budget balanceCAB Output gap

Sensitivity Revision to Output gap

Revision to deficit ratio



12 January 2007

The Real Time Dataset

• Output gap, actual balance, CAB from successive issues of OECD Economic Outlook: December 1995 (58) -December 2006 (78)



12 January 2007

Data Revisions: Output Gap

• Difference between data at time t+s and ex post data

• n=7 • 1995-2001



12 January 2007

Data Revisions: Deficits

• Difference between data at time t+s and ex post data

• n=7 • 1995-2001



12 January 2007

Data Revisions: CAB

Summary of OECD cyclically adjustment methodology

• Estimate elasticities of various budget components with respect to output gap

• Multiply these by output gaps– Some lags included for

tax revenues



12 January 2007

How well does the OECD Real Time Estimate Perform?

• Simple benchmark: construct our own simple output gap and CAD measure

• HP filter output• Plug in our estimate of output gap to OECDs

elasticity and deficit figures



12 January 2007

Comparison: Output Gap

• RMSE:– Thick line: OECD’s real

time output gap series vs OECD’s final output gap series

– Thin Line: Our real time output gap series vs OECD’s final output gap series

• OECD figures perform significantly better in real time • Over longer time horizons (s = 2,...,4) the difference is almost

negligible



12 January 2007

Comparison: CAB

• RMSE:– Thick line: OECD’s real

time CAB vs OECD’s final CAB

– Thin Line: Our real time CAB series vs our final CAB

– Dotted line: Our real time CAB series vs OECD’s final CAB

• OECD figures perform marginally better• Even if you take OECD final numbers as “correct”. OECDs own

real time data is only marginally better at estimating that completely different (and far simpler) methodology



12 January 2007

Early Warning?

• Measure of accuracy of real time figures• Fiscal Slippage: ex post CAB worsens by 1.5pp of GDP• If real time CAB slips by certain amount- trigger value-

then an alarm is sounded



12 January 2007

Early Warning?

• Two definitions of fiscal slippage– Fall of 1.5pp in CAB over 1yr



12 January 2007

1 year slippage definition



12 January 2007

Early Warning? (2)

• Two definitions of fiscal slippage– Fall of 2.0pp in CAB over 2yrs (t-2 to t, time t data)



12 January 2007

2 year slippage definition



12 January 2007

Deficit Revisions or Cyclical Adjustment?

• Apply RT cyclical adjustment to ex post deficit data

• Eliminates most of the missed alarm problem• …but doesn’t help the false alarm problem

Real time Data



12 January 2007

Deficit Revisions or Cyclical Adjustment? (2)

• 2 pp definition: similar story

• Eliminates most of the missed alarm problem• …but doesn’t help the false alarm problem

– False alarm problem even gets worse! Real time Data



12 January 2007

Data Revisions and Slippages

• CAB calculations are at their most unreliable when they are the most needed!!!



12 January 2007

Conclusions

• Using CABs for fiscal surveillance requires good quality figures in real time

• Real time CAB figures are unreliable– Output gap revisions– Deficit revisions also play a big role– Simple approach can almost match OECDs

methodology in real time– Can’t reliably pick out fiscal slippages– Real time CAB figures are most unreliable

when they are most needed

early warning or just wise after the event? the problem of using cyclically adjusted budget deficits...

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