The European Union’s fiscal policy framework imposes constraints on individual countries’ fiscal policies to ensure long-term financial sustainability. However, it is also designed to provide flexibility through the operation of “off-budget” automatic stabilisers. In practice, these rules have led to pro-cyclical measures in EU peripheral countries due to the way European institutions estimate the Non-Accelerating Wage Rate of Unemployment (NAWRU).
This new paper – just published in “Structural Change and Economic Dynamics” and written with Giovanni Carnazza and Matteo Sommacal – demonstrates the procyclical nature of the current mechanism. We combine empirical evidence covering 2002–2023 with a semi-analytical model of potential output and NAWRU dynamics to estimate the change in the Cyclical Component from endogenising the variables relevant to the business cycle.
Since the recent reform of the Stability and Growth Pact kept the core of this mechanism intact, the challenges identified for 2002–2023 are likely to persist in the years ahead.
The good news is that the fix could be carried out on a purely technical basis and would be relatively easy to implement.
Here the link to the paper.