What Small Countries Can Teach the World

1. What Small CountriesCan Teach the World Jeffrey Frankel Harpel Professor of Capital Formation & Growth,Harvard University & Director of Program in International Finance & Macroeconomics, National Bureau of Economic ResearchNBER Session, NABE Annual Meeting, Dallas, September 11, 2011

2. Countries need a model • In the past, countries choosing social systems, development strategies, or specific institutions usually looked to the big powers for inspiration • Europe, • USSR, • Japan, • US. Project Syndicate , Oct.2010.

3. Two decades ago, many thought the lesson of the 1980s had been that Japan’s variant of capitalism was the best model: • Including such institutions as: • Strategic trade policy, • relationship banking, • life-time employment… • Other countries should follow it. • The Japanese model quickly lost its luster in the 1990s.

4. One decade ago, many thought that the lesson of the 1990s had been that the US variant of capitalism was the best model – • Including American-style corporate governance: • Securities markets, • accounting standards, • compensation for CEOs (options…) • Other countries should follow. • The American model in turn lost its attractiveness in the decade of the 2000s.

5. To whom should countries around the world look for inspiration, now?  European Financial Review, 2011.

6. Meanwhile, many smaller countrieson the periphery have experimented with policies and institutions that could usefully be adopted by others. Institutions worth emulating. European Financial Review, 2011.

7. Countries that are small, newly independent, 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.

8. Some micro examples • Costa Rica in Central America and Mauritius in Africa each pulled ahead of its regional peers long ago.  • Among other decisions that worked out well for them, both countries have foregone a standing army. • The result in both cases: no-coup histories; • and financial savings that were used for good things, • such as education and investment. 

9. Singapore achieved rich country status with a unique development strategy.  • Among its many innovations were: • a paternalistic approach to saving; and • congestion pricing for auto traffic.

10. The price mechanism to address traffic congestion • has been emulated by London since 2003. • More cities should follow.

11. CCT programs • Mexico pioneered Conditional Cash Transfers (the OPORTUNIDADES program — originally called PROGRESA, launched in 1998).  • CCT programs have subsequently been emulated by many developing countries.  • Notably Lula’s BolsaFamilia in Brazil. • Two revolutions in one:  • (1) the specific idea of making poverty transfers contingent on child school attendance (which has been emulated even in NYC) • (2) the methodological idea of conducting controlled experiments to find out what policies work or don’t work, • which fed into the exciting Randomized Control Trials movement. 

12. Some small advanced countries also have lessons to offer.   • New Zealand led the way with Inflation Targeting, • along with many late-1980s liberalization reforms.   • Its Labor Party could even be given credit for pioneering the principle that some left-of-center governments can achieve economic liberalization better than their right-of-center opponents.

13. Ireland stressed Foreign Direct Investment.  • Estonia led the way in simplifying its tax system by means of a successful flat tax in 1994, • followed by Slovakia • and other small countries in Central/Eastern Europe.

14. In highlighting some very specific institutions that could be usefully applied elsewhere, I don’t mean to suggest that they can be effortlessly translated from one national context to another. • Nor do I mean to suggest that these examples are entirely responsible for the success of the economies identified.  • Indeed a few of these countries have recently been wrestling with severe problems. • But a country doesn’t have to be large like the U.S. to serve as a model for others.

15. My most important example: Chile’s fiscal institutions • Most developing countries in the past suffered from procyclical fiscal policy: • In boom times they would increase spending, • in downturns they were forced to cut back; • thereby exacerbating the business cycle. • 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-exporters. • Gavin & Perotti (1997), Calderón & Schmidt-Hebbel (2003) and Perry (2003). • The correlation of govt. spending & GDP > 0; • almost 1 for Oman, for example.

16. Correlations between Government spending & GDP 1960-2002 G always used to be pro-cyclical for most developing countries. Kaminsky, Reinhart&Vegh (2004) } procyclical countercyclical

17. Historic role reversal • Since 2000, one third of the EM/developing countries have “graduated” from procyclical fiscal policy to countercyclical, • running primary surpluses ,providing for future pension costs, & cutting debt during the 2002-07 boom. • By 2007, Latin America had cut its debt to 33% of GDP, • as compared to 63 % in the United States. • allowing easing in the 2008-09 global recession.

18. Correlations between Government spending & GDP 2000-2009 procyclical Frankel, Vegh&Vuletin(2011) In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy:Negative correlation of G & GDP. countercyclical

19. Debt levels in top 20 emerging markets are now< half those in rich countries(debt/GDP ratios ≈ 80%). • Some emerging markets have earned credit ratingshigher than some so-called advanced countries. • During the same period when these countries learned how to run countercyclical policy, it seems that the US and Europe forgot how. • They allowed large deficits during the expansion, • and now feel constrained to cut spending, despite depressed GDP. • How did they do it?

20. Chile in 2000 instituted a structural budget rule • The institution was formalized in law in 2006. • The rule: the government must set a target for the structural budget deficit, • which President Bachelet set at 0, • where “structural” is defined as 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.

21. Chile’s fiscal position strengthened immediately. • allowing national saving to rise from 21% to 24% by 2005. • 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, • By 2007, Chile had become a net creditor. • By 2010, its sovereign rating had climbed to A+, • ahead of some advanced countries: • Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).

22. In 2007-08, with copper prices spiking upward, the Bachelet government was under intense pressure to spend the revenue. • She & Fin.Min.Velasco held to the rule, saving most of it. • Their popularity ratings fell sharply. • When the 2009 recession hit and the copper price came back down, the government raised spending, mitigating the downturn. • The Ministers’popularity reached historic highsin 2009.

23. A budget target of zero may sound familiar • like the budget deficit ceilings that supposedly constrain members of euroland (deficits < 3 % of GDP under the Stability & Growth Pact) • or like the U.S. proposals for a Balanced Budget Amendment (deficit = 0). • But those attempts fail. Two reasons: • (1) They are too rigid to allow the need for deficits in recessions, counterbalanced by surpluses in good times.  • and lack credibility from the beginning. • But even structural budget rules fail. • Why? My hypothesis: • (2) Politicians make overly optimistic forecasts of growth & budgets, • thus avoiding cutbacks.

24. Official budget forecasts are biased toward optimism especially if GDP is currently high & especially at longer horizons 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.

25. Official budget forecasts are more biased toward optimismin 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.

26. The crucial institutional innovation in Chile • Chile has avoided over-optimistic official forecasts, • especially the historic pattern of over-exuberance in commodity booms. • How? • 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.

27. European Financial Review, 2011.

28. Appendix: US fiscal policysince 2001

29. The US public debate is framed as a battle between conservatives who philosophically believe in strong budgets & small government, and liberals who do not. • The right goal is budgets that allow surpluses in booms and deficits in recession. • 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. Not the right way to characterize the question.

30. US fiscal policy 2001-08 • The U.S. is an example of those overly optimistic government budget forecasts. • When the Bush administration took office in January 2001,it forecast $5 trillion in cumulative budget surpluses for the decade. • Its over-optimism took three forms: • 1) Overly optimistic economic/technical assumptions • E.g., not allowing for a possible future recession. • 2) Faulty economic theories regarding tax cuts: • the “Laffer Hypothesis” and “Starve the Beast” • 3) Tricks to force CBO to score the base budget • E.g., phony sun-setting of tax cuts in 2010, 2012 • Pretending each year that the wars in Iraq & Afghanistan would end.

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

32. US fiscal policy over the past decade,continued • The forecasted surpluses helped Bush launch a 10-year path of un-conservative 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 2011, although the economy is weak, Washington feels constrained by its debt to withdraw fiscal stimulus.

33. Faulty tax cut theory I -- Laffer Hypothesis:“Tax cuts stimulate activity enough to raise revenue”

34. Faulty tax cut theory II – The Starve the Beast Hypothesis:“Tax cuts lower revenue which forces spending cuts.”

35. “Starve the Beast” does not work: Tax cuts were not associated with spending cuts. To the contrary. Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spending. |Sharedsacrificeregime| |Taxcutregime | | Tcr | Tax cut regime |

36. This talk draws on the following writings • Some Big Ideas from Small Countries, European Financial Review, May 2011. • "Big Ideas from Small Countries,“ in Project Syndicate , Oct.2010. Blog . • "Mauritius: African Success Story,"forthcoming, S.Edwards, S.Johnson, & D.Weil,eds.  NBER WP 16569, Dec.2010. • "Over-optimism in Forecasts by Official Budget Agencies and Its Implications," forthcoming,Oxford Review of Economic Policy, 2011.  NBER WP 17239. • “A Solution to Fiscal Procyclicality:  The Structural Budget Institutions Pioneered by Chile,” forthcoming,Fiscal Policy and Macroeconomic Performance, Series on Central Banking Analysis, & Economic Policies , Nov. 2011.   NBER WP16945. • A Lesson from the South for Fiscal Policy in the US & Other Advanced Countries,"Comparative Economic Studies,Sept.2011.  • “On Graduation from Procyclicality,”withC.Végh&G.Vuletin, Aug.2011. VoxEU. • “Snake-Oil Tax Cuts,”EPIBriefing Paper 221, 2008.