Download Chile`s Solution to Fiscal Procyclicality

“Chile’s Solution to Fiscal Procyclicality”
Forthcoming, Transitions, Democracy Lab Blog, Foreign Policy
By Jeffrey Frankel, June 2012
These days, the news from Chile is dominated by the sagging popularity of
Conservative President Sebastian Piñera. But just four years ago, Chile was equally
turned off by his left-center predecessor, Michele Bachelet – though for completely
different reasons.
Bachelet’s low approval ratings in 2008 were largely due to her refusal to spend
the soaring receipts from copper exports. The world price of copper – Chile’s largest
export -- hit $800 per metric ton that year, an historic high in nominal terms and more
than quadruple the level of 2001. Yet her government insisted on saving most of the
proceeds for a rainy day.
Circumstances soon changed: By the time they completed their term in office in
early 2010, Bachelet and her finance minister, Andrés Velasco, enjoyed the highest
approval ratings of any president and cabinet minister since the return of democracy to
Chile.
The reversal can’t be attributed to the fortunes of the Chilean economy. Quite the
contrary: at the time, Chile was bearing the brunt of the global recession. In 2009, the
price of copper had fallen abruptly, growth had turned negative, and unemployment
topped 10 percent. But the government was able to respond with sharply increased
spending to cushion the blow and speed the recovery, drawing down revenues that had
been accumulated when the world couldn’t get enough Chilean copper. Now that the
rainy day had come, Bachelet and Velasco were viewed as heroes.
The significance of this episode is not that an especially wise or brave policy
prescription can make a very big difference – it can, but the idea of saving in a boom to
be able to spend in the bust is not new. And while action to this end is less common than
the words, there are certainly examples of governments that have shown the courage to
put away the fiscal punch bowl before the crowd has drunk its fill.
What the world needs – and, ironically, was delivered by Chile rather than by a
mature industrialized economy -- is institutions designed to produce good policies even
when the officials charged with carrying them out are vulnerable to wishful thinking or
inclined toward expediency. Indeed, Chile’s handling of the copper-price roller coaster
could serve as a template for other countries in which the political pressures to follow
“pro-cyclical” fiscal policies are very hard to resist.
The restraint on Chile’s fiscal policy is codified in law. The government must
announce a budget target – originally set at a surplus of one percent of GDP, but softened
to zero (i.e., budget balance) in 2009. That sounds a lot like the eurozone’s Stability and
Growth Pact, which was supposed to limit member-states’ deficits to three percent of
GDP. But unlike Chile’s rule, the SGP was born to fail. As everyone knows by now, the
fiscal limits were repeatedly violated, by members large and small.
In the first place, the original SGP was too rigid in that it didn’t allow
“countercyclical” fiscal policy – that is, policies that offset the changing tides of private
demand. It did not even allow budget deficits to rise endogenously as tax revenues fell in
recessions.
Chile’s rule beats the one-size-fits-all trap by targeting the structural budget
deficit, defining the acceptable level according to what the deficit would be in more
normal times. In a boom, the government can spend the increased revenues if and only if
the boom is structural, that is, permanent. If the bonanza is cyclical, that is temporary,
then the revenues must be saved. This approach has also been tried in Europe.
Switzerland successfully pioneered a structural budget rule, which Germany subsequently
emulated and now seeks to implant in the constitutions of other members of the euro,
under the “fiscal compact”. But here comes the second problem with these rules: who is
to forecast economic growth? Who is to determine (in real time) what is structural and
what is cyclical, that is, what is permanent and what is temporary? Politicians can always
attribute an excessive budget deficit to temporarily disappointing economic growth and
duck the issue of closing it – if they’re lucky, until they leave office. [Since there is no
way of proving what an unbiased forecast of growth is, there is no way of disproving the
politicians’ claim that the shortfall is not their responsibility.]
Chile’s structural balance regime limits the loopholes by specifying that the
government may run a deficit larger than the target only to the extent that (a) output falls
short of its long-run trend, or the price of copper is below its medium-term (ten-year)
equilibrium. Crucially, those numbers are not left to political officials to calculate. In the
middle of each year, panels of independent experts estimate them. [The experts on the
copper panel are drawn from mining companies, the financial sector, research centers,
and universities.] The government then follows prescribed procedures to translate the
numbers into the structural budget balance.
I’ve studied official government forecasts of economic growth rates and budget
balances in 33 countries. On average, there is a significant bias toward optimism, which
is stronger during economic upswings: growth leads officials to conclude that good times
will go on rolling indefinitely. This finding explains why so many governments fail to
repair the holes in their roofs while the sun is shining.
More surprisingly, in light of economists’ love affair with rules: the bias toward
smiley faces is stronger for countries that have SGP-type rules than for those that do not.
When a country’s budget deficit exceeds the rigid target, officials find it expedient to
forecast that things will get better next year [rather than taking unpopular and painful
action].
Nobody in Chile claims that the forecasts of experts are accurate. But they are far
less likely to be systematically biased than those cooked up by politicians. Indeed, unlike
the rest of the 33 countries, Chile has managed to produce forecasts that have not been
biased toward optimism since 2000.
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Part of the credit for Chile’s structural budget rule should go to the government of
Pres. Ricardo Lagos (2000-2006) and his finance minister, Nicolas Eyzaguirre. It
initiated the structural budget criterion, and delegated the calculations to experts. The
payoff, in the form of budget surpluses in good times, was immediate. Between 2000 and
2005, public savings – that is, the difference between revenues and expenditures rose
from 2.5 percent of GDP to 7.9 percent.
But in this first phase, the budget rule was not a formal mandate, and thus might
well have been violated in a crunch. The newly elected Bachelet government enshrined
the general framework in law in 2006. Global credit markets got the message: In
December of that year, Chile was awarded a sovereign debt rating of A, several notches
ahead of Mexico, Brazil and other Latin American peers.
The copper boom provided the real test of the Bachelet administration’s
determination to play by the rules. It was pressed hard to declare that the increase in the
price of copper was permanent, thereby justifying increased spending in good times. But
the expert panel ruled that most of the price increase was temporary, so that most of the
earnings had to be saved. And to its credit, the government supported the finding.
As a result, the fiscal surplus reached almost nine percent of GDP during the
boom. Chile used the surplus to pay down its debt to a mere four percent of GDP and was
still able to sock away a sum equal to about 12 percent of GDP in its sovereign wealth
fund. The country’s credit rating climbed to A+, the same as Japan’s. Which brings us
back to the beginning of our story: the rainy day fund was there to be spent in the
recession of 2008-09, when the stimulus was sorely needed. In short, Chile managed
what policymakers in most developing countries have only dreamed about: a truly
countercyclical fiscal policy.
There’s no compelling reason why a version of Chile’s structural budgeting
institutions couldn’t be emulated by other developing countries that are dependent on the
vagaries of commodity prices. The whole point, after all, is to design a system to work in
an environment in which politicians are as prone to myopia as teenagers.
The Chilean approach could be improved even further by making it illegal to fire
members of the panels. It is also worth thinking about making the structurally adjusted
targets actively (as opposed to passively) countercyclical. Bachelet and Velasco were
able to save more than required in the 2007-08 boom, allowing them to ease more than
required in the 2009 recession. Why not try to build that more aggressive approach into
the budgeting formula?
While we’re at it, why limit the Chilean approach to developing countries? Last
time I looked, budget discipline comes easy exactly nowhere.
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