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 Banque de France, Paris, January 13, 2011 Forthcoming, Fiscal Policy and Macroeconomic Performance, 2011, edited by Jordi Gali et al.Presented at 14th Annual Conference of the Central Bank of Chile,Oct. 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 Jan.2001, • it forecast a decade of $5 trillion in cumulative budget surpluses. • Some components of this over-optimistic forecast: • Over-optimistic macroeconomic assumptions • Growth forecasts. • An incoming OMB appointee raised estimate of labor’s income share. • Administration claims that tax cuts would raise the budget surplus: • Laffer Proposition • Starve the Beast Hypothesis.

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 fiscal expansion: • tax cuts • & accelerated spending • > twice Clinton’s rate of spending growth. • The results: • a cumulative $5 trillion in decade budget deficits. • Today, in 2011, despite high unemployment, Washington feels constrained by its debt to withdraw 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 & 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 in 2010, • & Portugal, Ireland, Spain & Italy. • Credit ratings marked down below “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 that official claims that it will be sustained are not credible, might even lead to looser fiscal outcomes • than if a more flexible rule had been specified at the outset. • Neut & Velasco (2003): theory. • Villafuerte et al(2010): in Latin America

11. The design of budget rules, continued • Obvious solution: specify budget targets in structural terms – conditional on GDP & other macroeconomic determinants. • But: 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 political officials 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.

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 is made by two panels of independent experts, • and thus is insulated from political pressure & wishful thinking. • Other countries might 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. • => It was able to respond to the 2008-09 recession • via fiscal expansion.

15. In 2008, with copper prices spiking up, the government of President Bachelet had beenunder 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 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. Figure 1b: Evolution of approval and disapproval of four Chilean presidents PresidentsPatricio Aylwin, Eduardo Frei, Ricardo Lagos and Michelle BacheletData: CEP, Encuesta Nacional de Opinion Publica, October 2009, www.cepchile.cl. Source: Engel et al (2011).

17. Three big themes of the last decade • The importance of volatile-priced minerals. • The importance of institutions. • The importanceofsmall countries • as possible new sources of lessons, • reversing the historic roles • in which only big advanced countries had been models.

18. Previously, fiscal policy was procyclicalin 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),Perry (2003), and Villafuerte, Lopez-Murphy & Ossowski (2010).

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

20. The historic role reversal • Over the last decade some 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.

21. 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.

22. 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.

23. 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.

24. Official forecasts are overly optimistic, continued • The bias appears in the US & other advanced countries, • not particularly among commodity-producers in these data. • 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.

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

26. Budget Forecasts are more Biased(4) at Longer Horizons & (5) in Booms

27. 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 Robust standard errors in parentheses, clustered by country.

28. (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.

29. 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. • (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.

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

31. * 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

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

33. 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

34. 10 or 30 years of data are notenough to discern reversion of real price of copper to long-run trend Appendix Figure 1

35. 226 years of data are enough to discern reversion of real price of copper to long-run trend Appendix Figure 2

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

37. 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

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

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

40. Conclusions • Official growth & budget forecasts tend toward wishful thinking: • unrealistic extrapolation of booms 3 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 pressuredto announce they are on track to meet 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 experts estimation of the long-run trends of copper prices & GDP.

41. 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 solely compute 10-year moving averages.

43. 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?

44. Appendix 1: Chilean politics

46. 2. The Greek sovereign debt problemFrankfurt & Brussels made 4 mistakes 2001: Admitted Greece to the euro. 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: No “Plan B” to restructure Greek debt (and save the bailout fund for more deserving banks & PIIGs).

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

48. 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.

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

50. 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. • Big emerging market countries are in better shape, • in an amazing & historic role reversal.