Discussion

The chapter by António Afonso and Peter Claeys provides a new method of calculating indicators of fiscal policy. The objective is to uncover any underlying past trends behind developments in public finances that may explain the current budgetary outlook. The authors propose their fiscal indicator as an alternative to the standard method of cyclically adjusting budget balances (CABs), which according to them does not properly reflect discretionary shifts under control of government. They interpret their results in great depth and conclude that a pro-cyclical bias in fiscal policy has resulted in a ratcheting-up in the size of governments. I do not disagree with the general thrust of their analysis of what has gone wrong with fiscal policy in EMU in recent years. Rather than commenting on the specific aspects of the four countries considered, I would like to give here a more general discussion of the method and the resulting indicator with a view to its usefulness for policy evaluation. The strength of the chapter is in my view that the approach based on structural VARs

allows for a simultaneous determination of a measure of cyclical output and fiscal balance. According to the authors their fiscal indicator has an advantage over standard CABs that it captures the so-called supply-side effects of fiscal policy. It should be pointed out that the criticism the authors put forward to justify their alternative approach, i.e. the difficulties in interpreting the structural balance in the absence of economic arguments to underpin the trend-cycle decomposition, applies chiefly to statistical trend extraction procedures and less to the production function approach adopted by the European Commission. Having said that, the proposed VAR-based indicators provide an interesting alternative to the CABs. The production function approach does not take into account the growth effects of fiscal policy due to taxation and productive spending, while this indicator in principle could include this. As the authors point out, it is therefore more consistent with the distinction between supply-and demand-side effects of fiscal policy adjustments found in recent DSGE models, which unlike earlier RBC models not only incorporate supply-side effects through wealth effects and labour/leisure choice but also give a larger role to demand-side effects by including financial frictions such as liquidity constraints. (Results from these models suggest fiscal policy has a significant demand-side effect and counter-cyclical fiscal policy has reduced output volatility.) A second advantage of the VAR-based indicators that the authors propose is that they

allow identification of confidence bands. The standard CABs have large cumulative uncertainty due to the various assumptions made in calculating output gaps but this is never shown explicitly. Just like Bayesian-estimated DSGE models (which have a proper structural identification), the SVAR method applied by the authors allows for an explicit assessment of uncertainty.