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

1. 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

2. Three stories of the past decade:set in the U.S., Europe, and Chile

3. 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.

4. Budget forecasts by the Bush White House subsequently had to be revised down every year Source: OMB

5. 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.

6. 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.

7. 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”.

8. Sovereign spreads for 5 euro countries shot up in the 1st half of 2010

9. Ratings for “Advanced Economies” Ratings for “Emerging Economies”

10. 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).

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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).

18. Correlations between Gov.t Spending & GDP G always used to be pro-cyclical for most developing countries. } Kaminsky, Reinhart & Vegh (2004) procyclical countercyclical

19. 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.

20. 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.

21. 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.

22. 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.

23. 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.

24. (3) Chile’s Official Budget Forecasts Are Not Prone to the Optimism Bias of Others’ Figure 8a

25. Figure 8c: Budget Forecasts are more Biased(4) in Booms & (5) at Longer Horizons

26. 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.

27. (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.

28. 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.

29. Table 6bGDP & inflation as determinants of budget balanceas a % of GDP, in 33 countries

30. * 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

31. (7) Figure 7b: Copper price movements dominate budget forecasting in Chile in the short term

32. 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

33. 10 or 30 years of data are notenough to discern reversion of real price of copper to long-run trendAppendix Figure 1:

34. 226 years of data are enough to discern reversion of real price of copper to long-run trendAppendix Figure 2:

35. (9) Uncertainty is genuinely higher when the spot price is high

36. 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

37. (10) Forecasts do internalize the tendency for copper prices to revert toward long-run equilibrium Figure 4: Copper prices spot, forward, & forecast2001-2010

38. 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.

39. 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.

40. 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.

42. 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?

43. Appendix 1: Chilean politics

45. 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).

46. Judging from spreads, 2001-07, investors put zero odds on a default by Greece or other Mediterranean countries Council on Foreign Relations

47. 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.

48. Predictions Greece will have re-structure its debt. The euro-zone will not break up. There is no legal provision for members to leave.

49. 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.

50. 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.