Fiscal policy and the assessment of output gaps in real time: An exercise in risk management

Fiscal policymakers are expected to conduct countercyclical policies to mitigate cyclical fluctuations of output, but the assessment of cyclical conditions in real time is subject to considerable uncertainty. They face two types of risk: (i) launching discretionary measures to support or dampen aggregate demand when no measures are required (type I error), or (ii) not launching any stabilising measures when this is warranted by cyclical conditions (type II error). A rational policymaker could manage these risks by correcting real-time estimates for past errors, notably the apparent tendency to underestimate good times when they occur. In practice, however, fiscal policy has been largely pro-cyclical or a-cyclical at best. Using statistical decision theory, we calculate thresholds for realtime output gap estimates beyond which governments could launch stabilisation measures, so as to reduce the risk of running pro-cyclical policies. We consider different preferences for avoiding type I or type II errors, and for addressing upside and downside growth risks. We show that the tendency to run pro-cyclical fiscal policy and the ensuing deficit bias can reflect two factors: a preference for activism that is, attaching a lower cost to type I errors, combined with an inclination to be gloomy about cyclical conditions.