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A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile. Jeffrey Frankel Harvard University Fiscal Policy and Macroeconomic Performance Fourteenth Annual Conference of the Central Bank of Chile October 21-22, 2010, Santiago.

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a solution to fiscal procyclicality the structural budget institutions pioneered by chile

A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile

Jeffrey Frankel

Harvard University

Fiscal Policy and Macroeconomic Performance

Fourteenth Annual Conference of the Central Bank of Chile

October 21-22, 2010, Santiago

story 1 a decade of us fiscal policy
Story #1: A decade of US fiscal policy
  • When the Bush administration took office
    • in January 2001,
    • it forecast a decade of $5 trillion in cumulative budget surpluses.
  • One component of this over-optimistic forecast:An incoming political appointee at OMB raised an obscure parameter – labor’s share of income – from its technocratic (CEA) estimate.
us fiscal policy over the past decade continued
US fiscal policy over the past decade,continued
  • The forecasted surpluses helped Bush launch a 10-year path of irresponsible fiscal policy:
    • tax cuts
    • & accelerated spending
      • > twice Clinton’s rate of spending growth.
  • The results:
    • a cumulative $5 trillion in decade budget deficits.
    • Today, in 2010, despite high unemployment, Washington feels constrained by its debt to withdrawal fiscal stimulus.
story 2 a decade of fiscal policy in euroland
Story #2: A decade of fiscal policy in Euroland
  • Many have proposed fiscal rules to overcome the political tendency toward budget deficits:
    • the occasional U.S. proposals for a Balanced Budget Amendment (deficit = 0);
    • or the budget ceilings that supposedly constrain euro members under the Stability & Growth Pact (deficits < 3 % of GDP );
    • and other rules in other countries.
slide7

But the SGP has failed

  • The fiscal limits were widely violated   
    • by big countries
      • France, Germany and Italy
    • and small
      • “PIGs”,
    • until the Greek debt crisis of 2010
      • when the budget rules’ failure could no longer be papered over.
  • Sovereign spreads shot up for Greece,
    • & Portugal & the others
    • below spreads for Chile & some other emerging markets.
  • Credit ratings marked down below “A”
    • while Chile’s ratings had moved above “A”.
slide9

Ratings for “Advanced Economies”

Ratings for “Emerging Economies”

the design of budget rules
The design of budget rules
  • The SGP was too rigid to allow the need for deficits in recessions, counterbalanced by surpluses in good times.
  • “Tougher” constraints on fiscal policy do not always increase effective budget discipline --
    • countries often violate the rules --
  • especially when a target that might have been reasonable ex ante, such as an unconditionally balanced budget, becomes unreasonable after an unexpected shock,
    • such as a severe fall in export prices or national output.
  • In an extreme set-up, a rule that is too rigid, so rigid that official claims that it will be sustained are not credible, might even lead to looser fiscal outcomes
    • than if a more moderate or flexible rule had been specified at the outset.
  • Neut & Velasco (2003).
the design of budget rules continued
The design of budget rules, continued
  • Obvious solution: specify budget targets in structural terms – conditional on GDP & other macroeconomic determinants.
  • The difficulty: Identifying what is structural vs. what is cyclical
    • is hard
    • and is prone to wishful thinking.
  • Thus specifying the budget rule in structural terms does not solve the problem, if politicians are the ones who judge what is structural.
story 3 a decade of chilean fiscal policy
Story #3: A decade of Chilean fiscal policy
  • In 2000 Chile instituted its structural budget rule.
  • The institution was formalized in law in 2006.
  • The structural budget deficit must be zero,
    • originally BS > 1% of GDP, then cut to ½ %, then 0 --
    • where structural is defined by output & copper price equal to their long-run trend values.
  • I.e., in a boom the government can only spend increased revenues that are deemed permanent; any temporary copper bonanzas must be saved
    • and vice versa.
the crucial institutional innovation in chile
The crucial institutional innovation in Chile
  • How has Chile avoided over-optimistic official forecasts?
    • especially the historic pattern of over-exuberance in commodity booms?
  • The estimation of the long-term path for GDP & the copper price -- and so how much of a copper bonanza can be spent -- is made by two panels of independent experts,
    • and thus is insulated from political pressure & wishful thinking.
  • Other countries could usefully emulate Chile’s innovation
    • or in other ways delegate to independent agencies estimation of structural budget deficit paths.
slide14

The Pay-off

  • Chile’s fiscal position strengthened immediately:
    • Public saving rose from 2.5 % of GDP in 2000 to 7.9 % in 2005
    • allowing national saving to rise from 21 % to 24 %.
  • Government debt fell sharply as a share of GDP and the sovereign spread gradually declined.
  • By 2006, Chile achieved a sovereign debt rating of A,
    • several notches ahead of Latin American peers.
  • By 2007 it had become a net creditor.
  • By 2010, Chile’s sovereign rating had climbed to A+,
    • ahead of some advanced countries:
    • Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).
  • => It was able to respond to the 2008-09 & 2010 shocks
    • via fiscal expansion.
slide15
In 2008, with copper prices spiking up, the government of President Bachelet was under intense pressure to spend the revenue.
    • She & Fin.Min.Velasco held to the rule, saving most of it.
    • Their popularity ratings reached historic lows.
  • When the recession hit and the copper price came back down, the government increased spending, mitigating the downturn.
    • Bachelet&Velasco’s popularity reached historic highs in 2009.
three big themes of the last decade
Three big themes of the last decade
  • The importance of volatile-priced minerals
    • and other commodities.
  • The importance of institutions
    • e.g., for setting fiscal policy.
  • The importance of emerging market countries
    • as a possible new source of lessons,
    • reversing the historic roles
    • in which only advanced countries had been models.
previously fiscal policy tended to be procyclical in developing countries
Previously, fiscal policy tended to be procyclical in developing countries:
  • Governments would raise spending in booms;
  • and then be forced to cut back in downturns.
      • Kaminsky, Reinhart & Vegh (2004), Talvi & Végh (2005),Alesina, Campante & Tabellini(2008), Mendoza & Oviedo (2006),Ilzetski & Vegh (2008) and Medas & Zakharova (2009).
  • Especially Latin American commodity-producers.
      • Gavin & Perotti (1997), Calderón & Schmidt-Hebbel (2003)and Perry (2003).
g always used to be pro cyclical for most developing countries

Correlations between Gov.t Spending & GDP

G always used to be pro-cyclical for most developing countries.

}

Kaminsky, Reinhart & Vegh (2004)

procyclical

countercyclical

the historic role reversal
The historic role reversal
  • Over the last decade many emerging market countries finally developed countercyclical fiscal policies:
  • They took advantage of the boom years 2003-2008
    • to run budget primary surpluses.
    • By 2007, Latin America had reduced its debt to 33% of GDP,
      • as compared to 63 % in the United States.
  • Debt levels among top-20 rich countries(debt/GDP ratios ≈ 80%) are now twice those of the top-20 emerging markets.
  • Some emerging markets have earned credit ratings higher than some so-called advanced countries.
ten econometric findings regarding bias toward optimism in official budget forecasts
Ten econometric findingsregarding bias toward optimism in official budget forecasts.
  • Official forecasts of budgets & GDP in a sample of 33 countries are overly optimistic on average.
  • The bias toward optimism is:
    • stronger the longer the forecast horizon.
    • greater among European governments that are under the budget rules in the SGP.
    • greater at the extremes of the business cycle,
      • particularly in booms.
  • The key macroeconomic input for budget forecasting in most countries: GDP. In Chile: the copper price.
10 econometric findings regarding bias toward optimism in official budget forecasts continued
10 econometric findings regarding bias toward optimism in official budget forecasts, continued.
  • Real copper prices mean-revert in the long run,
    • but this is not always readily perceived.
    • A mere 30 years of data cannot reject a random walk.
  • Uncertainty (option-implied volatility) is higher when copper prices are toward the top of the cycle.
  • Chile’s official forecasts are not overly optimistic.
  • Chile has apparently avoided the problem of official forecasts that unrealistically extrapolate in boom times.
official forecasts of budgets gdp are overly optimistic on average in a sample of 33 countries
Official forecasts of budgets & GDP are overly optimistic on averagein a sample of 33 countries
  • (1)Government forecasts of the budget balance(App. Table 1)
    • The average across all countries is an upward bias of:
      • 0.2% of GDP at the 1-year horizon,
      • 0.8% of GDP 2 years ahead,
      • and a hefty 1.5% at 3 years ahead.
  • (2)Government forecasts of the GDP growth rate(App.Table 2)
    • The average across all countries is an upward bias of:
      • 0.4 % when looking 1 year ahead,
      • 1.1 % at the 2-year horizon,
      • and 1.8% at 3 years.
official forecasts are overly optimistic continued
Official forecasts are overly optimistic, continued
  • The bias appears in the US & other advanced countries,
    • not particularly in emerging markets.
    • Chile on average under-forecast its growth rate,
      • by 0.8 % at the 1-year horizon.
  • The sample of 33 countries:
    • 26 from Europe (of which, 16 € members)
    • 1 other major advanced country (US), and
    • 3 advanced commodity-exporters (Australia, Canada, & NZ),
    • 3 middle-sized emerging market commodity-exporters (Chile, Mexico & South Africa).
    • Getting data on official forecasts
      • is very hard for others in this last category.
      • Easy for Europe.
slide26

Official budget forecasts are biased

more if GDP is currentlyhigh & especially at longerhorizons

Budget balance forecast error as % of GDP, Full dataset

33 countries

Variable is lagged so that it lines up with the year in which the forecast was made.*** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country.

budget balance forecast error as a of gdp full dataset

(6)Official budget forecasts are more optimistically biasedin countries subject to a budget deficit rule (SGP)

Budget balance forecast error as a % of GDP, Full Dataset

33 countries

*** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country.

budget forecasting is not easy
Budget forecasting is not easy
  • (7) The key macroeconomic input for forecasting budget balance in most countries: GDP.
  • In Chile: the copper price.
  • (8) Real copper prices mean-revert in the long run,
    • but this is not always readily perceived.
    • A mere 30 years of data cannot reject a random walk.
  • (9) Uncertainty (option-implied volatility) is higher when copper prices are toward the top of the cycle.
  • (10) But forecasts do internalize reversion to trend.
slide30

* p<0.05. Robust standard errors in parentheses

  • The copper forecast error is measured as: [log (Aug. 15-month forward price) – log (average end-of-month price, Jan.–Dec., of the next year)]*100
7 figure 7b copper price movements dominate budget forecasting in chile in the short term
(7) Figure 7b: Copper price movements dominate budget forecasting in Chile in the short term
do copper prices random walk or revert toward a long run trend
Do copper prices random-walk?Or revert toward a long-run? trend
  • 30 years of data cannot reject a random walk.
  • But, then, a priori calculations suggest there is not enough power in 30 years of data to find mean-reversion even if it is there.
    • One should need about 200 years of data.
  • (8) Sure enough, copper prices revert to trend
    • with statistical significance,
    • when tested on 217 years of data (1784-2009);
    • at an estimated speed of 0.13 per year
slide33
10 or 30 years of data are notenough to discern reversion of real price of copper to long-run trendAppendix Figure 1:
slide34
226 years of data are enough to discern reversion of real price of copper to long-run trendAppendix Figure 2:
slide36

Table 4: Uncertainty Is Greater When the Copper Price is Above its Long-run TrendRegression of option-implied copper price volatility on log (real spot price) – linear trend(log real spot price, using data for 230 years)

*** p<0.01, ** p<0.05 Robust standard errors in parentheses

table 3 do private forecasters recognize mean reversion in copper prices
Table 3: Do private forecasters recognize mean reversion in copper prices?

Yes

*** p<0.01 Robust standard errors in parentheses

LHS [ln(real forward price)-ln(real spot price)]*100 Real price ≡ nominal price divided by US CPI.

15-month forward is Jan.1989 – July 2010. 27-month is July 1993- July 2010. 63-month is Oct.2002.Data source: LME via Bloomberg for copper prices. IMF IFS for US CPI.

conclusions
Conclusions
  • Official growth & budget forecasts tend toward wishful thinking:
    • unrealistic extrapolation of booms three years into the future.
  • The bias is worse among the European countries supposedly subject to the budget rules of the SGP,
    • presumably because government forecasters feel pressured to be able to announce they are on track to meet the budget targets even if they are not.
  • Chile is not subject to the same bias toward over-optimism in forecasts of the budget, growth, or the all-important copper price.
  • The key innovation that has allowed Chile to achieve countercyclical fiscal policy:
    • not just a structural budget rule in itself,
    • but rather the regime that entrusts to two panels of independent experts estimation of the extent to which copper prices & GDP depart from their long-run averages.
application to other countries
Application to other countries
  • Any country could adopt the Chilean mechanism,
    • not just commodity-exporters.
  • Suggestion: give the panels more institutional independence
    • as is familiar from central banking:
      • requirements for professional qualifications of the members
      • and laws protecting them from being fired.
  • Two open questions:
    • Are the budget rules to be interpreted as ex ante or ex post?
    • How much of the structural budget calculations are to be delegated to the independent panels of experts?
      • The minimalist approach: they are mandated solely to compute 10-year moving averages.
appendices
Appendices
  • The political success of the Chilean government’s fiscal strategy, 2008-09
  • The Greek sovereign debt problem
  • Three big themes of the last decade
  • What should US fiscal policy be now?
2 the greek sovereign debt problem frankfurt brussels made 3 mistakes
2. The Greek sovereign debt problemFrankfurt & Brussels made 3 mistakes

2002-09: Did not allow spreads to open up between sovereign debt of Greece & Germany.

Winter 2010: Did not tell Greece to go to the IMF. Preferred instead to “handle it internally.”

Still today: No “Plan B” to restructure Greek debt (and save the bailout fund for more deserving banks & PIIGs).

slide46
Judging from spreads, 2001-07, investors put zero odds on a default by Greece or other Mediterranean countries

Council on Foreign Relations

slide47
Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June.
  • Even when the Greek crisis erupted, leaders in Brussels & Frankfurt seemed to view it as a black swan,
    • instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier,
      • and many others in history,
        • including among European countries.
predictions
Predictions

Greece will have re-structure its debt.

The euro-zone will not break up.

There is no legal provision for members to leave.

slide49
Sovereign debt worries...
  • The next big asset market to fall
    • after the stock market in 2000
    • the housing market in 2006
    • and banking in 2008
  • will be sovereign debt
    • among the advanced economies.
  • The big emerging market countries are in much better shape,
    • in an amazing & historic role reversal.
a remarkable role reversal
A remarkable role-reversal:
  • Debt/GDP of the top 20 rich countries (≈ 80%) is already twice that of the top 20 emerging markets;
  • and rising rapidly.
  • By 2014 (at ≈ 120%), it could be triple.
appendix 3 three big themes of the last decade
Appendix 3: Three big themes of the last decade
  • The importance of volatile-priced minerals
    • and other commodities.
  • The importance of institutions
    • including for setting fiscal policy.
  • The importance of emerging market countries
    • as a possible new source of lessons,
    • reversing the historic roles
    • in which advanced countries had been the models
      • e.g., Japan in the 1980s
      • And the US in the 1990s.
where to look for lessons
Where to look for lessons?
  • Two decades ago, many had drawn a lesson from the 1980’s: Japan’s variant of capitalism was the best model,
    • that other countries around the world should and would follow it.
    • But the Japanese model quickly lost its luster in the 1990’s.
  • A decade ago, many thought that the lesson of the 1990’s was that the US variant of capitalism was the best model,
    • that other countries should and would follow.
    • The American model lost its attractiveness in the 2000’s.
  • So, where should countries look now, in 2010, for models of economic success to emulate?
  • Perhaps to the periphery of the world economy.
big lessons from small countries
Big lessons from small countries
  • Some smaller and less-rich countries have experimented with policies & institutions that could usefully be adopted by some of the “advanced countries.”
  • Two illustrations from microeconomics.
    • 1st, Singapore pioneered the use of the price mechanism to reduce traffic congestion in its urban center.
      • London emulated Singapore, successfully adopting congestion pricing in 2003; other big cities should do the same.
    • 2nd, Mexico pioneered Conditional Cash Transfer programs,
      • making poverty benefits contingent on children’s school attendance.
      • They have been emulated widely, embraced even in NYC.
on the larger theme that advanced economies could learn some things from developing countries
On the larger theme that advanced economies could learn some things from developing countries
  • This line of argument is not meant as an attack on Western values or modes of thought.
  • It is not a celebration of Confucian values or native folk remedies in the Andes or Africa.
  • In my view, when Americans lectured others on the virtues of fiscal discipline, market-based economics, the rule of law, and electoral democracy, they were mostly right.
  • Where they were wrong:
    • the failure to see that their own country needed to be on the receiving end just as much as developing countries.
advanced economies could learn some things from developing countries continued
Advanced economies could learn some things from developing countries,continued
  • Countries that are small, or newly independent, or far-away, or emerging from a devastating war, are often more free to experiment,
    • than is the US or other large established countries.
  • Not all the experiments will succeed.
  • But some will.
  • The results may include useful lessons.
advanced economies could learn some things from developing countries continued56
Advanced economies could learn some things from developing countries, continued
  • In some cases, Western institutions were successfully transplanted to other countries in the past, and now needed to be re-imported.
  • An analogy.
    • In the latter part of the 19th century the vineyards of France were destroyed by Phylloxera vastatrix, amicroscopic aphid.
    • Eventually a desperate last resort was tried: grafting susceptible European vines onto resistant American root stock.
    • It saved the European vineyards.
    • The New World had come to the rescue of the Old.
slide57

The last decade has seen a historic reversal in roles between advanced countries and emerging/developing countries regarding fiscal policy.

  • Some of the latter took advantage of the 2002-08 expansion
    • to run surpluses, pay down debt,
    • and provide for future pension costs;
  • allowing budget deficits in the 2008-09 recession.
  • = A counter-cyclical fiscal policy
  • The US, UK & some other advanced countries have forgotten how.
appendix 4 what should be the overall stance of us fiscal policy
Appendix 4: What should be the overall stance of US fiscal policy?
  • Moving toward discipline in up-times
    • 1993-2000. It did.
    • 2003-2007, It didn’t.
  • Expansionary during down-times
    • 2010. It isn’t.
slide59

The US public discussion is framed like a battle between conservatives who philosophically believe in strong budgets & small government, and liberals who do not. Not the right way to characterize the debate. [1]

  • (1) The right goal should be budgets that allow surpluses in booms and deficits in recession.
  • (2) The correlation between how loudly an American politician proclaims a belief in fiscal conservatism and how likely he is to take corresponding policy steps < 0.

[1] Forget that small government is classically supposed to be the aim of “liberals,” in the 19th century definition, not “conservatives.” My point is different: those who call themselves conservatives in practice tend to adopt policies that are the opposite of fiscal conservatism. I call them “illiberal.” “Republican & Democratic Presidents Have Switched Economic Policies”Milken Inst.Rev.2003.

three pieces of evidence to support the claim that fiscal conservatives are not
Three pieces of evidence to support the claim that “fiscal conservatives” are not:
  • (i) The voting pattern among the 258 Congressmen who signed an unconditional pledge not to raise taxes:
    • As of 2004, they had voted for more spending than those who did not sign the pledge. [2]
  • (ii) The pattern of spending under Republican presidents.[3]
  • (iii) The pattern of states whose Senators win pork & other federal spending.[4]
  • [2]William Gale & Brennan Kelly, 2004, “The ‘No New Taxes’ Pledge,” Tax Notes, July.
  • [3] JF “Snake-Oil Tax Cuts,” EPI, Briefing Paper 221. 2008. 
  • [4]JF Red States, Blue States and the Distribution of Federal Spending, 3/31/2010.
slide61

(ii) Spending & deficts both rose sharply when Presidents Reagan, Bush I, & Bush II took office.

Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spending.
iii states ranked by federal spending received per tax dollar paid in 2005
(iii) States ranked by federal spending receivedper tax dollar paid in 2005

versus party vote ratio in preceding election

“red”states

Republican states take home significantly more federal $ (relative to taxes paid)than Democratic states

big inflow of US $

“blue”states

low inflow of US $

u s fiscal policy in 2010 2011
U.S. fiscal policy in 2010-2011?
  • What changes in American fiscal policy would be desirable at the current juncture,
    • if politics were not an obstacle?
  • On the one hand, the economy is still weak.
  • On the other hand, the U.S. can’t wait until the recovery is complete to tackle the long run fiscal problem.
  • A two-part strategy:
  • Current steps to extend the fiscal stimulus,
    • designed to maximize bang for the buck.
  • Current steps to lock in future progress back toward fiscal discipline in the long run.
u s fiscal policy in 2010 2011 continued
U.S. fiscal policy in 2010-2011, continued
  • Maximizing bang for the buck ≡ fiscal stimulus that gives the most demand per $ added to long-term debt.
  • Example that would minimize bang for the buck:
    • proposal to make permanent the 2010 estate tax abolition .
    • Almost as poorly targeted: proposal to prevent the Bush tax cuts from expiring in 2011 for those households > $250,000.
  • If the stimulus has to take the form of tax cuts, then the best options are:
    • extending President Obama’s “Make Work Pay” tax cuts,
    • fixing the Alternative Minimum Tax, and
    • extending the Bush tax cuts for those households < $250,000.
    • Some business tax cuts could also give high bang for the buck.
      • such as temporary credits for investment or hiring.
u s fiscal policy in 2010 2011 continued65
U.S. fiscal policy in 2010-2011, continued
  • But spending boosts demand more than tax cuts do,
    • because the latter are partly saved.
  • Extend elements of the Obama stimulus
    • such as infrastructure investment and
    • giving money to the states
      • so that they don’t have to lay off teachers, policemen, firemen, subway drivers & construction workers.
u s fiscal policy in 2010 2011 continued66
U.S. fiscal policy in 2010-2011, continued
  • How does one take steps today to lock in future fiscal consolidation?
    • Not by raising taxes or cutting spending today (see above);
    • nor by promising to do so in a year or two (not credible).
    • There are lots of economically sensible proposals
      • for spending to eliminate,
      • more efficient taxes to switch to,
      • and “tax expenditures” to cut.
u s fiscal policy in 2010 2011 continued67
U.S. fiscal policy in 2010-2011, continued
  • One big reform might work best: pass legislation today to put Social Security on a sound financial footing in the long term.
  • It would consist of a combination
    • of raising the retirement age
      • just a little (in proportion to lengthening life spans)
    • and slowing the growth of benefits for future retirees
      • just a little (perhaps by “progressive indexation).
  • If Washington could fix Social Security,
    • it would address the long-term fiscal outlook,
    • yet would create no drag for the current fragile recovery.