Fiscal procyclicality and output forecast errors

Government spending in the developing world has historically been procyclical. Traditional explanations for this have mostly revolved around the explicit or implicit notion that fiscal procyclicality is the deliberate result of political economy distortions and weak institutions. Because of revisions in output growth forecasts around the world since the global financial crisis, two recent explanations in the literature have gained increasing support: (i) over-optimism in output forecasts as a cause of procyclicality, and (ii) real-time data, as opposed to ex-post data, as an explanation for policymakers' intended responses to output fluctuations, which in practice tend to deliver less procyclical “intentions” than reliance on ex-post data. This study revisits the implications of output forecast errors on fiscal procyclicality in light of these two recent strands in the literature. For this study, a simple conceptual framework was developed and empirical evidence presented using output forecasts for 101 countries. The results showed that: (i) over-optimism is neither necessary nor sufficient to explain fiscal procyclicality, and (ii) there is no reason to accept the interpretation that forecast errors have “unfortunate” systematic effects on fiscal procyclicality. Traditional political economy arguments help explain how governments handle unanticipated output fluctuations.