This paper discusses how the technical foundations of the EU’s fiscal rules constrain the fiscal space in EU countries in the context of the COVID-19 pandemic. We review the evidence on how estimates of potential output, which are at the heart of essential control indicators in EU fiscal surveillance, were revised in the ten years running up to the COVID-19 pandemic, and how these revisions affected the fiscal stance of EU countries. We provide first evidence for downward revisions in the European Commission’s potential output estimates against the background of the COVID-19 shock across the EU27 countries, and we assess the potential consequences in terms of fiscal space. According to our results, one additional percentage point in predicted losses of actual output is associated with a loss in potential output of about 0.6 percentage points. Given the importance of model-based estimates in the EU’s fiscal rules, avoiding pro-cyclical fiscal tightening will require that policymakers’ hands are not tied by overly pessimistic views on the development of potential output.
Ball, L. (2014), Long-term damage from the Great Recession in OECD countries, European Journal of Economics and Economic Policies, 11(2), 149–160.
Blanchard, O. and D. Leigh (2013), Growth forecast errors and fiscal multipliers, IMF Working Paper, WP/13/1.
Blanchard, O., E. Cerutti and L. Summers (2015), Inflation and activity—two explorations and their monetary policy implications, IMF Working Paper, WP/15/230.
Buti, M., N. Carnot, A. Hristov, K. Mc Morrow, W. Roeger and V. Vandermeulen (2019, 23 September), Potential output and EU fiscal surveillance, VOX CEPR Policy Portal, https://voxeu.org/article/potential-output-and-eu-fiscal-surveillance (2 December 2019).
Ciucci, M. and A. Zoppe (2016), Potential output estimates and their role in the EU fiscal policy surveillance, European Parliament Briefing, PE574.407.
Coibion, O., Y. Gorodnichenko and M. Ulate (2018), The cyclical sensitivity in estimates of potential output, Brookings Papers on Economic Activity, 2018(2), 343–441.
Costantini, O. (2017), Political economy of the Stability and Growth Pact, European Journal of Economics and Economic Policies: Intervention, 14(3), 333–350.
De Grauwe, P. and Y. Ji (2013), From Panic-Driven Austerity to Symmetric Macroeconomic Policies in the Eurozone, Journal of Common Market Studies, 51(S1), 31–41.
European Commission (2015), Making the best use of the flexibility within the existing rules of the Stability and Growth Pact, COM(2015)012 final.
European Commission (2019), Vade mecum on the Stability and Growth Pact: 2019 edition, European Economy, Institutional papers, 101.
European Commission (2020a), Communication from the Commission to the Council on the activation of the general escape clause of the Stability and Growth Pact, COM(2020) 123 final.
European Commission (2020b), Communication from the Commission: Economic governance review, SWD (2020) 2010 final.
Fatas, A. (2019), Fiscal policy, potential output, and the shifting goalposts, IMF Economic Review, 67(3), 684–702.
Fatas, A. and L. Summers (2018), The permanent effects of fiscal consolidation, Journal of International Economics, 112(C), 238–250.
Fontanari, C., A. Palumbo and C. Salvatori (2019), Potential output in theory and practice: A revision and update of Okun’s original method, Institute for New Economic Thinking Working Paper, 93.
Gualtieri, R. (2019, 23 October), Letter from Italy to the European Commission, https://ec.europa.eu/info/sites/info/files/economy-finance/minister_gualtieri_-_letter_to_ec_23_10_2019_1.pdf (3 August 2019).
Havik, K., K. Mc Morrow, F. Orlandi, C. Planas, R. Raciborski, W. Roeger, A. Rossi, A. Thum-Thysen and V. Vandermeulen (2014), The Production Function Methodology for Calculating Potential Growth Rates & Output Gaps, European Economy Economic Papers, 535.
Heimberger, P. (2017), Did Fiscal Consolidation Cause the Double-Dip Recession in the Euro Area?, Review of Keynesian Economics, 5(3), 439–458.
Heimberger, P. and J. Kapeller (2017), The performativity of potential output: Pro-cyclicality and path dependency in coordinating European fiscal policies, Review of International Political Economy, 24(5), 904–928.
Heimberger, P. (2019), Italy’s crisis: the fault line of the euro area, wiiw Monthly Report, 12/2019, 13–18.
Heimberger, P., J. Huber and J. Kapeller (2019), The power of economic models: The case of the EU’s fiscal regulation framework, Socio-Economic Review, forthcoming.
Heimberger, P. and J. Kapeller (2017), The performativity of potential output: Pro-cyclicality and path dependency in coordinating European fiscal policies, Review of International Political Economy, 24(5), 909.
Hein, E. and A. Truger (2014), Future fiscal and debt policies: Germany in the context of the European Monetary Union, in P. Arestis, M. Sawyer (eds.), Fiscal and debt policies for the future, 76–115, Springer.
House, C., C. Proebsting and L. Tesar (2019), Austerity in the aftermath of the great recession, Journal of Monetary Economics, forthcoming.
Jarocinski, M. and M. Lenza (2018), An inflation-predicting measure of the output gap in the euro area, Journal of Money, Credit and Banking, 50(6), 1189–1224.
Jorda, O. and A. Taylor (2016), The Time for Austerity: Estimating the Average Treatment Effect of Fiscal Policy, Economic Journal, 126(590), 219–255.
Klär, E. (2013), Potential economic variables and actual economic policies in Europe, Intereconomics, 48(1), 33–40, https://www.intereconomics.eu/contents/year/2013/number/1/article/potential-economic-variables-and-actual-economic-policies-in-europe.html (25 May 2020).
Mourre, G., C. Astarita and S. Princen (2014), Adjusting the budget balance for the business cycle: the EU methodology, European Economy Economic Papers, 536.
Palumbo, A. (2015), Studying growth in the modern classical approach: Theoretical and empirical implications for the analysis of potential output, Review of Political Economy, 27(3), 282–307.
Tereanu, E., A. Tuladhar and A. Simone (2014), Structural balance targeting and output gap uncertainty, IMF Working Paper, 14/107.
Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (2012), T/SCG/EN.
Truger, A. (2015), The Fiscal Compact, cyclical adjustment and the remaining leeway for expansionary fiscal policies in the Euro Area, Panoeconomicus, 62(2), 157–175.
Open Access funding provided by ZBW — Leibniz Information Centre for Economics.
Philipp Heimberger, Vienna Institute for International Economic Studies; and Johannes Kepler University Linz, Austria.
About this article
Cite this article
Heimberger, P. Potential Output, EU Fiscal Surveillance and the COVID-19 Shock. Intereconomics 55, 167–174 (2020). https://doi.org/10.1007/s10272-020-0895-z