Why eurozone countries need independent fiscal watchdogs

What happens if countries in a monetary union set ambitious goals for budget deficits and growth?  They start making overly optimistic forecasts. This paper by Jeffrey Frankel and Jess Schreger from Harvard has some informative graphs. The first graph below shows how the two year ahead forecasting error differs per country. Greece, Ireland, Portugal, and Spain come out on top. The second graph shows how the average forecasting error varies over time. The forecasting error dropped just before the introduction of the euro and rose soon after.

The authors then go on to show that “euro area governments making forecasts while in violation of the EDP with an independent fiscal institution that makes independent budget forecasts have a mean bias that is smaller by 2.9% of GDP at the one-year horizon and 2.6% of GDP at the two year horizon, compared to a euro area country violating the EDP without such an independent fiscal institution.” I rest my case.

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