Fiscal Over-optimism

From a paper by Jeffrey Frankel (Oxford Review of Economic Policy, Winter 2011). A draft is here.  

From the abstract:

The paper studies forecasts of real growth rates and budget balances made by official government agencies among 33 countries.

He adds: 

In general, the forecasts are found: (i) to have a positive average bias, (ii) to be more biased in booms, and (iii) to be even more biased at the 3-year horizon than at shorter horizons.

This over-optimism in official forecasts can help explain excessive budget deficits, especially the failure to run surpluses during periods of high output: if a boom is forecasted to last indefinitely, retrenchment is treated as unnecessary. Many believe that better fiscal policy can be obtained by means of rules such as ceilings for the deficit or, better yet, the structural deficit. But we also find: (iv) countries subject to a budget rule, in the form of euroland’s Stability and Growth Pact (SGP), make official forecasts of growth and budget deficits that are even more biased and more correlated with booms than do other countries.

Frankel writes about Chile:

Chile’s official forecasts have not been subject to the same bias toward over- optimism that typifies other countries. If anything, its forecasts have erred on the pessimistic side. The official forecast of real growth has fallen short of the ex post numbers by an average of 0.8 per cent at the one-year horizon. The official forecast of the budget surplus as a percentage of GDP has fallen short of the ex post numbers by an average of 1.4 per cent at the one-year horizon. In Figure 1a, the observations corresponding to Chile are indicated by Xs. Most lie below the line of zero budget forecast errors and almost all of those that lie above miss by only a small margin. There is no tendency for the forecast error to rise in booms, as with other countries.  

Chile’s fiscal institutions have apparently enabled it to avoid the problem of official forecasts that fall prey to wishful thinking. Downturns or budget deficits are not explained away with unrealistic forecasts of dramatic improvement; booms and surpluses are not unrealistically extrapolated into the future.  

Any country could apply variants of the Chilean fiscal device. Countries could set up independent institutions charged by law with estimating the output gap and such other budget-relevant macroeconomic variables as the inflation rate and the fractions of GDP going to wage versus non-wage income. A reinforcement of the Chilean idea would be to give the panels legal independence. There could be laws protecting them from being fired, as there are for governors of independent central banks. One could imagine also broadening the responsibility of such panels beyond simply estimating the long-run trend in income. The principle of a separation of decision-making powers would be retained: only elected political leaders determine how spending is allocated or taxes are raised.