Over-optimistic official forecasts and fiscal rules in the eurozone

Abstract

Eurozone members are supposedly constrained by the fiscal caps of the Stability and Growth Pact. Yet ever since the birth of the euro, members have postponed painful adjustment. Wishful thinking has played an important role in this failure. We find that governments' forecasts are biased in the optimistic direction, especially during booms. Eurozone governments are especially over-optimistic when the budget deficit is over the 3% cap at the time the forecasts are made. Those exceeding this cap systematically but falsely forecast a rapid future improvement. The new fiscal compact among the euro countries is supposed to make budget rules more binding by putting them into laws and constitutions at the national level. But biased forecasts can defeat budget rules. What is the record in Europe with national rules? The bias is less among eurozone countries that have adopted certain rules at the national level, particularly creating an independent fiscal institution that provides independent forecasts. JEL classification numbers: E62, H50

Permanent budget surpluses as a fiscal regime

“…At the same time, it was emphatically not the consequence of any formalized pressure on governments. Quite the contrary, the literature generally assumes that institutional rules will induce over-optimism in official forecasting (Frankel/Schreger 2013).…”

“…Empirically, Frankel and Schreger (2013) find that most countries tend to make systematically over-optimistic forecasts of budgetary developments. As their data also show, however, the opposite is the case in long surplus countries, which systematically underestimated their surpluses.…”

UK Taxes and Tax Revenues: Composition and Trends

“…Schreger [9] studied government revenue and budget forecasts in Eurozone countries, finding lower bias in those countries that have adopted budget rules. Leal et al [10] argue in favour of transparent methods in revenue forecasting combined with clear procedures.…”

The euro crisis: Where to from here?

“…Greek official forecasts were always over-optimistic. Source: Frankel and Schreger (2013). debt overhang looks like the nail in the coffin of the longer term objective of limiting moral hazard. It offers absolution precisely on the margin where countries in the future will in any case have the most trouble resisting the temptation to sin again, the margin where they cross the 60% threshold.…”

“…9), but most of the other euro members have also been overly optimistic, as Figure 10 illustrates. When a Eurozone government finds itself with a deficit above the 3% limit, it adjusts its forecast to show the deficit coming back down below the limit in the coming few years, without adjusting its actual policies (Frankel and Schreger, 2013). This statistically significant tendency is reduced when the country gives the fiscal forecasting job to an independent agency.…”