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 University John Lewis, De Nederlandsche Bank Rasmus Kattai, Bank of Estonia Estonian Economic Association Annual Conference Pärnu, 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 Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 12 January 2007 Introduction

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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?

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 12 January 2007 The Basic Problem 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 balanceCABOutput gap Sensitivity Revision to Output gap Revision to deficit ratio

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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)

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 12 January 2007 Data Revisions: Output Gap Difference between data at time t+s and ex post data n=

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 12 January 2007 Data Revisions: Deficits Difference between data at time t+s and ex post data n=

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 12 January 2007 Early Warning? Two definitions of fiscal slippage –Fall of 1.5pp in CAB over 1yr

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 12 January year slippage definition

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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)

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 12 January year slippage definition

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 12 January 2007 Data Revisions and Slippages CAB calculations are at their most unreliable when they are the most needed!!!

John Lewis Economics and Research Division De Nederlandsche Bank Early Warning or Wise After the Event? Estonian Economic Association 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