This document analyzes Spain's structural budget balance and unemployment rate between 1980-2012. It discusses two key points: 1) Estimates of Spain's structural unemployment rate and budget balance are highly uncertain and sensitive to assumptions. Alternative estimates show Spain's structural deficit in 2012 was around 3% of GDP rather than the European Commission's estimate of 5.9%. 2) Reducing unemployment and fiscal consolidation are mutually reinforcing but happen at different speeds. Structural reforms can lower unemployment and the deficit over time. Given uncertainties, a gradual fiscal adjustment in Spain is recommended while continuing reforms to support growth.

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Budget balance, structural unemployment and
fiscal adjustments: The Spanish case
Javier Andrés, Rafael Doménech, 5 April 2013
Fiscal adjustment and structural reform are key parts of Eurozone bailout packages (or key features of
government policy that aims to avoid such bailouts). This column argues that patience is the most prized virtue of
policymakers implementing fiscal adjustment and structural reform. Reducing unemployment and fiscal Javier Andrés
consolidation are mutually reinforcing, but they move at different speeds. Professor of Economic Analysis,
University of Valencia; and
Visiting Professor, University of
40 A A Glasgow
Related
One of the most important questions in the current
process of fiscal consolidation in many developed Eurozone: Looking for growth
Laurence Boone, Céline Renucci, Ruben Segura-
economies concerns the size and the pace of the
Cayuela
adjustment. An excessive and/or too-fast fiscal
Fiscal policy in Europe: Searching for the right
retrenchment can have dramatic effects on balance
unemployment and growth, while if it is too slow, it can Marco Buti, Nicolas Carnot
prove to be ineffective and lack credibility in the eyes
European imbalances
of the financial markets. Thus, when the debt-to-GDP Hans-Werner Sinn, Akos Valentinyi Rafael Doménech
ratio is high and there is limited fiscal space, the Chief Economist for Developed
challenge is to find the proper balance between Economies, BBVA Research; and
growth, efficiency and credibility of the fiscal adjustment. Professor of Economics,
University of Valencia
One of the main factors that determine this credibility is whether the implementation of the fiscal
adjustment brings about an effective reduction in the structural budget balance, i.e., the public
Don't Miss
deficit that exists once the effect of the economic cycle has been adjusted for. The European
Commission has just published its winter forecasts for 2013, where it has updated its estimates on Pay attention to the WTO
leadership contest: It
structural budget balance. According to these estimates, for ten of European economies the matters!
structural public deficit exceeds 3% of their GDP. Spain is the country with the third highest Hoekman, Mavroidis
structural deficit in 2012, after Ireland and the UK, with 5.9% of GDP.1 Deposit insurance after
Iceland and Cyprus
The budget balance and the unemployment rate Sibert
The capital controls in
Such a high estimated structural deficit for the Spanish economy is particularly striking considering Cyprus and the Icelandic
that the unemployment rate was 25% in 2012, which is prima facie evidence of a strong negative experience
cyclical position. As the public deficit converges towards its structural level (when the economy Danielsson
tends towards a neutral cyclical situation), unemployment simultaneously converges towards its Cyprus: What are the
alternatives?
structural rate. However, neither of these structural components can be observed and have to be
Beck
estimated, introducing uncertainty in key variables for economic policy.
Cyprus is different
Figure 1 represents the Spanish budget balance, as a percentage of GDP, against the Annunziata
unemployment rate, which appears on the horizontal axis; the negative correlation among these Cyprus: The next blunder
variables stems from the effects of the automatic stabilisers.2 Figure 1 also displays two vertical Wyplosz
dashed red lines corresponding to the structural unemployment rates in 2006 and 2012 estimated
by the Commission.3 According to these estimates, structural unemployment appears to be highly Most Read
volatile and strongly procyclical ranging from 11% (when the current unemployment rate was 8.5%)
This Month All Time
up to 21.7% (25% respectively), almost eleven points of difference in only six years for a structural
component that should be otherwise fairly stable. Thus, these estimates imply that most of the fall in Cyprus: The next blunder
economic activity in Spain in recent years has meant a fall in potential GDP. To put it another way, Wyplosz
that practically two thirds (0.65 of a percentage points) of each point of increase in the Walking back from Cyprus
Gulati, Buchheit
unemployment rate can be considered as structural.
Cyprus is different
Figure 1. Spain, general government budget balance and unemployment rate, 1980-2012 (source: Annunziata

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On top of these vertical dashed red lines for the structural unemployment rates for 2006 and 2012,
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the chart displays the structural budget balance estimated by the Commission for those two years;
1.7% and -5.9% respectively. Given that the nominal budget balance in 2006 was 2.4% of GDP, we Weekly Digest
can infer that the cyclical balance estimated at the highest point of the real-estate boom reached
barely 0.7 percentage points of GDP. This is contradictory with the estimates by some authors (for
example, Martínez-Mongay, Maza and Yaniz 2007), who found that between two and three points of
GDP could be considered to be transitory revenues in those years.
According to the decomposition estimated by the Commission, in 2012 for each point of cyclical
unemployment the budget balance fell by 0.63 of a percentage point; this value is the result of
dividing the cyclical fiscal balance (that is, -2.1% is equal to -7%, -1% and 5.9%), including one-offs
(1%), by the cyclical unemployment rate (that is 3.3% is equal to 25% minus 21.7%). At least for
2012, the sensitivity of the cyclical component of the budget balance to the unemployment rate
estimated by the Commission is very close to the value obtained by directly regressing the total
budget balance on the unemployment rate (the regression coefficient is equal to -0.68).4
Therefore, Figure 1 makes clear that the structural budget balance estimated by the Commission
depends on two crucial factors:
1) The estimated structural unemployment rate.
2) The sensitivity of the budget balance to cyclical unemployment.
An alternative estimate of the structural budget balance
How sensitive is the structural budget balance to these two factors? To answer this question we
introduce two changes with important implications:
The structural unemployment rate is estimated following an alternative procedure base on the
Okun's Law (see, for example, Ball, Leigh and Loungani, 2013), according to which this rate
was 14% in 2006 and 18% in 2012, less volatile and procyclical than the one estimated by the
Commission. Consequently cyclical unemployment is more persistent.5
The sensitivity of the cyclical budget balance to cyclical unemployment has been re-estimated,
giving a ratio of -0.7, very similar to the regression coefficient of the current budget balance
over the unemployment rate (-0.68) and slightly above the elasticity estimated by the
Commission (-0.63).6
With these new estimates the structural budget balance in 2012 can be calculated projecting the
observed deficit onto the new vertical solid green line in the figure: 3%. Likewise, the structural
budget balance in 2006 would have been in deficit (-1.5%), even though there was a positive
balance due to the asset-boom effect, largely on revenues. The comparison between the results
from these two methods highlights the paramount importance of uncertainties in both, the estimate
of structural unemployment (e.g. Staiger, Stock, and Watson 1997), similar to that existing with
trend GDP (Larch and Turrini 2009), and in the sensitivity of the deficit to the economic cycle. The
question of which method to use, however, may be based on diverse qualitative judgements:

3. For 2006 the alternative approximation provides results that are more consistent with the
existence of an asset boom.
Between 2007 and 2008 non-financial public revenue fell 4.1 points as a percentage of GDP, while
the structural unemployment rate estimated by the European Commission would have risen by only
1.4 points, from 11.8 to 13.2%:
The Spanish economy is implementing reforms (in the labour market and in the goods and
services markets) that should reduce structural unemployment and, therefore, the structural
deficit.
A reasonably high number of fiscal-adjustment measures in 2010, 2011 and, particularly, in
2012, can be considered genuinely structural.
Economic policy implications
According to our calculations, the Spanish economy would still need three points of GDP fiscal
adjustments in the years to come to reach the budget equilibrium mandatory in the new Spanish
Budget Stability and Financial Stability Act. With the calculations of the Commission the required
adjustment would have to be almost twice as high.
Given the uncertainty regarding the estimation of structural budget balances and unemployment,
and about the negative effects of fiscal adjustments on economic activity, it is advisable to be
cautious and not carry out fiscal adjustments that could end up being excessive, at least until further
information allows a more precise estimate of the structural deficit. The implication of these
discrepancies for this year’s fiscal objective is straightforward. As Buti and Carnot (2013) remind us,
the IMF (2012) considers a structural adjustment pace of 1% a year as a useful guideline, and the
SGP requires an annual structural adjustment of 0.5% or more in the case of vulnerable countries.
The problem is how to make this rule operational in a new fiscal target for 2013, given the
uncertainty surrounding the structural unemployment rate. Assuming that the unemployment rate
will increase from 25% to 26,9% (as in the recent winter forecasts by the Commission), the question
is by how much is the structural unemployment affected by this increase in the observed rate. In
fact, depending on the assumptions about the increase of the structural unemployment rate (and
given an initial budget deficit of 6.7% in 2012), a fiscal target ranging from -6.1% to -6.7% in 2013
could be sufficient to ensure a 1% structural adjustment this year.7
Given these uncertainties, 2013 could be a year of transition in which it would suffice to apply the
fiscal measures already under way, working rather on the quality of the fiscal adjustment. For
example, substituting the one-off measures in 2012 by permanent ones and implementing much
more selective measures, which might allow improvements in the efficiency of public
administrations, based on items with lesser short term impact on growth and wellbeing.
Meanwhile, it is necessary to continue to apply new structural reforms and also to give time to those
that are already under way to do their job. As a result of these reforms, for each point of reduction in
structural unemployment, we reduce the structural deficit by 0.7 percentage points of GDP. In short,
the increase in potential growth, the reduction of structural unemployment and the fiscal
consolidation are processes that mutually reinforce each other.
References
Ball, L, D Leigh and P Loungani (2013), “Okun’s Law: Fit at 50?”, NBER Working Paper 18668.
Buti, M and N Carnot (2013), “Fiscal policy in Europe: Searching for the right balance”, VoxEU.org,
14 March.
Corrales, F, Doménech, R and J Varela (2002), "El Saldo Presupuestario Cíclico y Estructural de la
Economía Española", Hacienda Pública Española, 1(3), 1-26.
Denis C, Grenouilleau D, McMorrow K and W Roeger (2006), “Calculating Potential Growth Rates
and Output Gaps – A Revised Production Function Approach”, Economic Papers 247, European
Commission.
Fedelino, A, A Ivanova and M Horton (2009), “Computing Cyclically Adjusted Balances and
Automatic Stabilizers”, Technical Notes and Manuals, IMF.
IMF (2012), “Nurturing credibility while managing risks to growth”, Fiscal Monitor Update, July.
Larch, M, and A Turrini (2009), “The cyclically-adjusted Budget balance in EU fiscal policy making:

4. A love at first sight turned into a mature relationship”, Economic Papers 374, European
Commission.
Martínez-Mongay, C, L A Maza Lasierra and J Yaniz Igal (2007), “Asset Booms and Tax Receipts:
The case of Spain, 1995-200”, European Economy Economic Papers 293.
Mourre, G, G M Isbasoiu, D Paternoster and M Salto (2013), “The cyclically-adjusted budget
balance used in the EU fiscal framework: an update”, Economic Papers 478, European
Commission.
Staiger, D, J H Stock and M W Watson (1997), “How Precise Are Estimates of the Natural Rate of
Unemployment?”, in C D Romer and D H Romer (eds.), Reducing Inflation: Motivation and Strategy,
University of Chicago Press, 195–246.
1 Given that the deficit for 2012 was 7% and that the one-offs measures estimated by the
Commission represent 1% of GDP, this means that the cyclical component of the public deficit only
accounts for 2.1 percentage points of GDP. In other words, according to the Commission most of
the deficit in 2012 is largely due to its structural component.
2 The correlation between the budget balance and the unemployment rate was equal to -0.84
between 1980 and 2012.
3 See Denis et al (2006) for a description of the method used to estimate the structural
unemployment rate.
4 This was not the case in 2006, when the cyclical budget balance was 0.8% and the cyclical
employment -2,46%. The slope for that year (-0.33) was half of the slope estimated in 2012, and for
the period 1995-2012 has been equal to -0.456. The changes in these elasticities are explained by
the fact that the in the method implemented by the European Commission, the sensitivity of the
deficit to the economic cycle depends on the elasticity of revenues to their respective tax bases, and
of the latter to the output gap and not to the unemployment rate (see, Fedelino, Ivanova and Horton,
2009, and Mourre et al, 2013).
5 It could be argued that many jobs that have been destroyed are of a permanent nature (for
example, in the construction sector). Unless there is a complete hysteresis, the permanent
destruction of jobs in certain specific sectors does not necessarily mean that the workers who held
these jobs will become permanently unemployed, thus prompting an increase in the structural
unemployment rate.
6 To obtain the elasticity of the cyclical budget balance to the cyclical unemployment rate we follow
the procedure described by Corrales, Doménech and Varela (2002), but using the unemployment
rate instead than the GDP.
7 One possibility is to assume that structural unemployment rate in 2013 will increase in the same
proportion as the one estimated by the Commission from 2006 to 2012 (65% of the increase of the
unemployment rate was due to its structural component). On the contrary, according to our
alternative estimate, the structural unemployment rate increased only 4 pp out of the 16,5 points
observed in the current unemployment rate, that is, only 24 per cent of the total increase would be
explained by its structural component.. The implications of these different assumptions in terms of
the expected increase of the cyclical unemployment rate in 2013 are huge (0.67 points vs 1.44).
Given that the preliminary estimate of the budget balance in 2012 was -6.7%, first we could add
between -0.4 and -1.0% of expected cyclical budget balance in 2013 (the elasticity, -0.63 vs -0.70,
times the increase of the cyclical unemployment rate, 0.67 vs 1.44). Second, we subtract 1% of
structural fiscal consolidation. Under these assumptions, the 2013 fiscal target would range from
-6.1% to -6.7%.
40
Topics: Europe's nations and regions
Tags: Eurozone crisis, fiscal policy, Spain, structural adjustment, unemployment
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