The performativity of potential output: pro-cyclicality and path dependency in coordinating European fiscal policies

ABSTRACT

This paper analyzes the performative impact of the European Commission's model for estimating ‘potential output’, which is used as a yardstick for measuring the ‘structural budget balance’ of EU countries and, hence, is crucial for coordinating European fiscal policies. In pre-crisis years, potential output estimates promoted the build-up of private debt, housing bubbles and macroeconomic imbalances. After the financial crisis, these model estimates were revised downwards, which increased fiscal consolidation pressures. By focusing on the euro area's economies during 1999–2014, we show how the model's estimates influence actual economic outcomes. We identify two major economic impacts of the potential output model. First, the political implications of the model led to pro-cyclical feedback loops, reinforcing prevailing economic developments. Second, the model has contributed to national lock-ins on path dependent debt trajectories, fueling ‘structural polarization’ between core and periphery countries.

KEYWORDS:

• Performativity
• potential output
• path dependency
• Eurozone crisis
• fiscal policy
• austerity

Acknowledgments

The Institute for New Economic Thinking supported this work under Grant INO1500015. The authors thank Bernhard Schütz, Claudius Gräbner, Stephan Pühringer, Georg Feigl, Stefan Steinerberger, Leonhard Dobusch and Mario Holzner as well as three anonymous referees for helpful comments. All remaining errors are our own.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. Hence, the roots of the Eurozone crisis in the years prior to the financial crisis of 2008/2009 lie not in excessive fiscal deficits and public debt, although the crisis has created severe sovereign debt problems from 2010 onwards (e.g. de Grauwe and Ji 2014; Lane 2012; Shambaugh 2012).

2. The Cobb–Douglas framework used by the Commission is well established, although many criticisms have been put forward that challenge its theoretical foundations and empirical usage (e.g. Felipe and McCombie 2014).

3. Criticisms related to measures of the capital stock are profound but beyond the scope of this paper; see Felipe and McCombie (2014) for a recent literature review.

4. The Commission's forecast from December 2007 provides time-series data for potential output for all EU countries through 2009 (we exclude five countries for which the 2007 data could not be compared to 2015 data). We take this pre-crisis data, denote them by PO**, and extend all time-series beyond 2009 by means of log-linear extrapolation. Specifically, we compute the average annual change in the logarithm of PO** during 2000–2009, and then assume that potential output has increased at a constant rate from 2010 to 2014 (see Ball 2014, 150).

5. Partly and to varying degrees across countries, revisions in potential output were also due the collapse in the growth rate of the capital stock (e.g. Darvas 2013; Klär 2013; Palumbo 2015).

Additional information

Funding

The Institute for New Economic Thinking [grant number INO1500015].

Notes on contributors

Philipp Heimberger

Philipp Heimberger works as an economist at the Vienna Institute for International Economic Studies (Vienna, Austria) and at the Institute for Comprehensive Analysis of the Economy (Johannes Kepler University Linz, Austria).

Jakob Kapeller

Jakob Kapeller is assistant professor at the Johannes Kepler University Linz (Department of Economics) and acts as head of the Institute for Comprehensive Analysis of the Economy (Linz, Austria).