Days of future past? The reform of the European fiscal framework, the (enduring) role of the structural balance and the pro-cyclical bias of potential GDP endogeneity

Giovanni Carnazza and Emilio Carnevali

Discussion Papers from Dipartimento di Economia e Management (DEM), University of Pisa, Pisa, Italy

Abstract: The European fiscal framework has recently been reformed, yet the concept of structural balance still plays a crucial role within it. This paper proposes a multidimensional approach to scrutinize the pro-cyclical tendencies embedded in European economic policies arising from the European Commission’s calculation methodology of potential output and structural balance. Initially, a theoretical model shows the vicious cycle dynamic that characterises the fiscal adjustment process during a recession when potential output is dependent on actual output. Subsequently, numerical simulations juxtapose this dynamic with a counterfactual scenario where potential output is only influenced by long-term supply factors. Finally, employing dynamic panel data analysis covering 26 EU countries from 1995 to 2023, on an annual basis, empirical evidence is presented to show the pro-cyclical nature of fiscal policies adopted by European governments. Importantly, these estimates facilitate the isolation of the proportion of the pro-cyclical effect attributed solely to the bias stemming from the endogeneity of potential GDP.

Keywords: European fiscal framework; fiscal (pro-)cyclicality; (endogenous) output gap; structural balance; pro-cyclical bias (search for similar items in EconPapers)
JEL-codes: C51 E32 E62 H62 (search for similar items in EconPapers)
Date: 2024-04-01
New Economics Papers: this item is included in nep-eec
Note: ISSN 2039-1854
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Persistent link: https://EconPapers.repec.org/RePEc:pie:dsedps:2024/306

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