‘The “structural deficit” is surely one of the most esoteric concepts ever to have figured in an international treaty. It means the fiscal deficit that would occur if a country’s GDP was at its full potential ... This approach assumes that it is possible to define a potential growth rate that depends only on supply-side factors (rate of productivity growth, capital stock, active labour force, equilibrium employment rate). In reality the European Commission’s method, written into the Treaty, means that its estimate of potential output is always very close to the level actually achieved, particularly in a period of recession.’ (Les Économistes Atterrés, 2012: 105-6) They argue that the supply-side factors listed are all dragged down by recession, and go on to show that if, instead, it is assumed that potential output has continued to expand at its average rate, the output gap would have been three times greater for France in 2011 than the EC’s estimate. The reasons for this downward bias in the estimates of potential output can be explored in the parallel case of the UK.

Traditionally, there have been three main approaches to measuring potential output, and thus the output gap (OBR 2011; IFS 2010: ch.1):

- • filters that mechanically extract a smoothed trend from a time series; • filters that mechanically extract a smoothed trend from a time series;
- • a production function to measure potential output from known measures of inputs • a production function to measure potential output from known measures of inputs and of total factor productivity;
- • indicators based on assessments, mostly from surveys, of unused capacity, • indicators based on assessments, mostly from surveys, of unused capacity, labour market conditions and productivity trends.

In the UK, the third approach was adopted by the Treasury in 2003, and confirmed in HM Treasury (2008). The Office for Budget Responsibility initially took over the Treasury method after it was set up by the incoming Coalition government in June 2010 (OBR 2010), but they have since attempted to refine it through a review of alternative approaches (OBR 2011). However, even among UK bodies using the same methodology, for the fiscal year 2009-10 estimates of the OG varied between -3% and -6% of potential GDP; using the accepted ratio of 0.5 in year 1, such a difference of 3 percentage points would translate into a 1.5 percentage- 1.3).5 point difference in the estimate of the structural deficit (IFS 2011: ch.1 Figs 1.2 and

Even before we delve into the underlying methodology, there has been considerable debate about not only the variation in OG estimates between different sources, but also the extent to which OG estimates for any given year are revised through time. The OECD, which uses a production function method, finds that approach bedevilled by the unreliability of estimates of total factor productivity (Bouis et al. 2012); a recent independent study of the same OECD data found that the uncertainty of OG estimates, measured by the extent of their later revision, has actually increased over time (Chiu & Wieladek 2012).

While the Treasury/OBR method appears more realistic, it is immensely cumbersome, since the approach is based upon listing a large number of potential indicators of spare productive capacity, measuring them (with appropriate statistical testing for the stability of these measures over time), and then assigning weights to these different components (for full details see OBR, 2011). Each of these stages involves subjective judgements, and just as importantly, many of the individual measures are themselves based upon business and other surveys in which the respondents are asked to provide their own assessment.

The crucial issue concerns whether the measurement of productive potential is accurate. In the UK, Chancellor Osborne (backed by the IFS and most commentators) argued that the OG had shrunk significantly (and therefore the SD had risen) because the 2008-9 crisis had