What Lessons Do Developing Countries Have for Fiscal Policy in the US?

1. What Lessons Do Developing Countries Have for Fiscal Policy in the US? Jeffrey Frankel,Professor, Harvard UniversitySTERN SCHOOL & INDIA PLANNING COMMISSION WORKSHOPON “REVIVING THE FOCUS ON LONG TERM GROWTH AND EMPLOYMENT IN THE ADVANCED ECONOMIES”Stern School of Business, NYU, Oct. 7-8, 2010

2. Where to look for lessons? • Two decades ago, many had drawn a lesson from the 1980s: Japan’s variant of capitalism was the best model; • other countries around the world should & would follow it. • But the Japanese model quickly lost its luster in the 1990s. • A decade ago, many thought that the lesson of the 1990s 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 2000s. • So, where should countries look now, in 2010, for models of economic success to emulate? • Perhaps to the periphery of the world economy.

3. 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.

4. 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, • the “crony capitalism” point made famous by Simon Johnson.

5. 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.

6. 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.

7. What should be the overall stance of US fiscal policy? • Expansionary during down-times • 2010. It isn’t. • Moving back toward discipline in up-times • 1993-2000. It did. • 2003-2007, It didn’t. • 2012- ?

8. 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.

9. Previously, fiscal policy tended to be procyclical in developing countries-- that is, destabilizing: • 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).

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

11. The historic reversal in developing countries • Over the last decade many emerging market countries finally developed countercyclical or stabilizing 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 ratingshigher than some so-called advanced countries. • Korea now has a better credit rating that Portugal. • Not only Chile & China, but also Malaysia, Mexico, Poland & South Africa, now have higher credit ratings than Greece or Iceland. • As a result these countries were able to ease budgets in 2008-09, helping recovery from the recession.

12. Two stories of the past decade:One set in U.S., the other in Chile • When the Bush administration took office in January 2001,it forecast $5 trillion in cumulative budget surpluses for the decade. • One component of this over-optimistic forecast:An incoming political appointee at OMB raised an obscure parameter – the share of labor income in GDP – from its long-time technocratic (CEA) estimate. Story #1: US fiscal policy

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

14. 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 a weak economy, Washington feels constrained by its debt to withdrawal fiscal stimulus.

15. Story #2: Chile in 2000 instituted a structural budget rule • The institution was formalized in law in 2006. • The rule: the structural budget deficit must be zero, • 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 much be saved.

16. Chile’s fiscal position strengthened immediately. • allowing national saving to rise from 20.6% to 23.6% 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, • several notches ahead of Latin American peers. • By 2007 Chile had become a net creditor. • By June 2010, its sovereign rating had climbed to A+, • ahead of some advanced countries: • Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).

17. By 2008. with copper prices spiking upward, 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. • The Ministers’ popularity reached historic highs in 2009.

18. 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 occasional U.S. proposals for a Balanced Budget Amendment (deficit = 0). • But those attempts have failed, because they are too rigid to allow the need for deficits in recessions, counterbalanced by surpluses in good times. • Specifying the budget rule in structural terms does not solve the problem, if politicians are the ones who judge what is structural and what is cyclical.

19. 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.

20. 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.

21. 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.

22. 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.

23. 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.

24. (ii) Spending & deficits 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.

25. (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 $

26. 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.

27. 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. • Also 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.

28. 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.

29. 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.

30. 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 on the current fragile recovery.

32. Appendices • Econometric tests of hypotheses regarding bias toward optimism in official budget forecasts. • The political success of the Chilean government’s fiscal strategy, 2008-09.

33. Econometrically supported hypotheses regarding 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 is stronger the longer the forecast horizon. • The bias is greater among European governments that are politically subject to the budget rules in the SGP. • The bias toward optimism is greater at the extremes of the business cycle, particularly in booms. • The key macroeconomic input for budget forecastingin most countries: GDP. In Chile: the copper price.

34. Econometrically supported hypotheses 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.