A Solution to Fiscal Procyclicality: A Solution to Fiscal Procyclicality: The Structural Budget Institutions The Structural Budget Institutions

Pioneered by ChilePioneered by Chile

Jeffrey FrankelJeffrey Frankel Harvard UniversityHarvard University

Fiscal Policy and Macroeconomic PerformanceFiscal Policy and Macroeconomic PerformanceFourteenth Annual Conference of the Central Bank of ChileFourteenth Annual Conference of the Central Bank of Chile

October 21-22, 2010, SantiagoOctober 21-22, 2010, Santiago

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Three stories of the past decade:Three stories of the past decade:

set in the U.S., Europe, and Chileset in the U.S., Europe, and Chile

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Story #1: A decade of US fiscal policyStory #1: A decade of US fiscal policy

• When the Bush administration took officeWhen the Bush administration took office – in January 2001,in January 2001,

– it forecast a decade of $5 trillion in cumulative budget surpluses.it forecast a decade of $5 trillion in cumulative budget surpluses.

• One component of this over-optimistic forecast:One component of this over-optimistic forecast:An incoming political appointee at OMB raised an obscure parameter An incoming political appointee at OMB raised an obscure parameter – labor’s share of income – from its technocratic (CEA) estimate.– labor’s share of income – from its technocratic (CEA) estimate.

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Budget forecasts by the Bush Budget forecasts by the Bush White House White House subsequently had to subsequently had to

be revised down every yearbe revised down every year

Jan.2001

Aug.2001

Jan.2002

Aug.2002

Jan.2003

Aug.2003

Jan.2004

-500

-400

-300

-200

-100

0

100

200

300

400U

S$ b

n

2002 2003 2004Source: OMB

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US fiscal policy over the past decade,US fiscal policy over the past decade, continuedcontinued

• The forecasted surpluses helped Bush launch The forecasted surpluses helped Bush launch a 10-year path of irresponsible fiscal policy:a 10-year path of irresponsible fiscal policy:– tax cuts tax cuts – & accelerated spending & accelerated spending

• > twice Clinton’s rate of spending growth.> twice Clinton’s rate of spending growth.

• The results:The results:

– a cumulative $5 trillion in decade budget a cumulative $5 trillion in decade budget deficitsdeficits..

– Today, in 2010, despite high unemployment, Today, in 2010, despite high unemployment, Washington feels constrained by its debt Washington feels constrained by its debt to withdrawal fiscal stimulus.to withdrawal fiscal stimulus.

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• Many have proposed fiscal rules to overcome Many have proposed fiscal rules to overcome the political tendency toward budget deficits:the political tendency toward budget deficits:– the occasional U.S. proposals the occasional U.S. proposals

for a Balanced Budget Amendment (deficit = 0);for a Balanced Budget Amendment (deficit = 0);– or the budget ceilings that supposedly constrain euro or the budget ceilings that supposedly constrain euro

members under the Stability & Growth Pact members under the Stability & Growth Pact (deficits < 3 % of GDP );(deficits < 3 % of GDP );

– and other rules in other countries.and other rules in other countries.

Story #2: A decade of Story #2: A decade of fiscal policy in Eurolandfiscal policy in Euroland

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• The fiscal limits were widely violated   The fiscal limits were widely violated   

– by big countriesby big countries• France, Germany and ItalyFrance, Germany and Italy

– and smalland small• ““PIGs”,PIGs”,

– until the Greek debt crisis of 2010until the Greek debt crisis of 2010• when the budget rules’ failure when the budget rules’ failure

could no longer be papered over.could no longer be papered over.

• Sovereign spreads shot up for Greece, Sovereign spreads shot up for Greece, – & Portugal & the others& Portugal & the others– below spreads for Chile & some other emerging markets.below spreads for Chile & some other emerging markets.

• Credit ratings marked down below “A”Credit ratings marked down below “A”– while Chile’s ratings had moved while Chile’s ratings had moved aboveabove “A”. “A”.

But the SGP has failedBut the SGP has failed

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

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Ratings for “Emerging Economies”Ratings for “Advanced Economies”

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The design of budget The design of budget rulesrules

• The SGP was too rigid to allow the need for deficits The SGP was too rigid to allow the need for deficits in recessions, in recessions, counterbalanced by surpluses in good timescounterbalanced by surpluses in good times..

• “ “Tougher” constraints on fiscal policy do not Tougher” constraints on fiscal policy do not always increase effective budget discipline --always increase effective budget discipline -- – countries often violate the rules --countries often violate the rules --

• especially when a target that might have been reasonable especially when a target that might have been reasonable ex ante, such as an unconditionally balanced budget, ex ante, such as an unconditionally balanced budget, becomes unreasonable after an unexpected shock, becomes unreasonable after an unexpected shock, – such as a severe fall in export prices or national output. 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 In an extreme set-up, a rule that is too rigid, so rigid that official claims that it will be sustained are not credible, official claims that it will be sustained are not credible, might even lead to looser fiscal outcomes might even lead to looser fiscal outcomes – than if a more moderate or flexible rule had been specified at the outset.than if a more moderate or flexible rule had been specified at the outset.

• Neut & Velasco (2003).Neut & Velasco (2003).

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The design of budget rules, The design of budget rules, continuedcontinued

• Obvious solution: Obvious solution: specify budget targets in structural terms – specify budget targets in structural terms – conditional on GDP conditional on GDP & other macroeconomic determinants.& other macroeconomic determinants.

• The difficulty: The difficulty: Identifying what is structural vs. what is cyclicalIdentifying what is structural vs. what is cyclical

– is hardis hard

– and is prone to wishful thinking.and is prone to wishful thinking.

• Thus specifying the budget rule in structural terms Thus specifying the budget rule in structural terms does not solve the problem, if politicians does not solve the problem, if politicians are the ones who judge what is structural.are the ones who judge what is structural.   

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Story #3: A decade Story #3: A decade of of Chilean fiscal policyChilean fiscal policy

• In 2000 Chile instituted its structural budget rule.In 2000 Chile instituted its structural budget rule.

• The institution was formalized in law in 2006.The institution was formalized in law in 2006.

• The structural budget deficit must be zero,The structural budget deficit must be zero,– originally BS > 1% of GDP, then cut to ½ %, then 0 --originally BS > 1% of GDP, then cut to ½ %, then 0 --– where structural is defined by output & copper price where structural is defined by output & copper price

equal to their long-run trend values.equal to their long-run trend values.

• I.e., in a boom the government can only spend increased I.e., in a boom the government can only spend increased revenues that are deemed permanent; revenues that are deemed permanent; any temporary copper bonanzas must be savedany temporary copper bonanzas must be saved– and vice versa.and vice versa.

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The crucial institutional innovation in ChileThe crucial institutional innovation in Chile

• How has Chile avoided over-optimistic official forecasts?How has Chile avoided over-optimistic official forecasts?– especially the historic pattern of especially the historic pattern of

over-exuberance in commodity booms?over-exuberance in commodity booms?

• The estimation of the long-term path The estimation of the long-term path for GDP & the copper price for GDP & the copper price -- and so how much of a copper bonanza can be spent -- -- and so how much of a copper bonanza can be spent -- is made by two panels of independent experts,is made by two panels of independent experts,– and thus is insulated from political pressure & wishful thinking.and thus is insulated from political pressure & wishful thinking.

• Other countries could usefully emulate Chile’s innovationOther countries could usefully emulate Chile’s innovation– or in other ways delegate to independent agencies or in other ways delegate to independent agencies

estimation of structural budget deficit paths.estimation of structural budget deficit paths.

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• Chile’s fiscal position strengthened immediately: Chile’s fiscal position strengthened immediately: – Public saving rose from 2.5 % of GDP in 2000 to 7.9 % in 2005Public saving rose from 2.5 % of GDP in 2000 to 7.9 % in 2005– allowing national saving to rise from 21 % to 24 %.allowing national saving to rise from 21 % to 24 %.

• Government debt fell sharply as a share of GDP Government debt fell sharply as a share of GDP and the sovereign spread gradually declined. and the sovereign spread gradually declined.

• By 2006, Chile achieved a sovereign debt rating of A, By 2006, Chile achieved a sovereign debt rating of A, – several notches ahead of Latin American peers.several notches ahead of Latin American peers.

• By 2007 it had become a net creditor. By 2007 it had become a net creditor. • By 2010, Chile’s sovereign rating had climbed to A+, By 2010, Chile’s sovereign rating had climbed to A+,

– ahead of some advanced countries: ahead of some advanced countries: – Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).

• => It was able to respond to the 2008-09 => It was able to respond to the 2008-09 & & 2010 shocks2010 shocks– via fiscal expansion.via fiscal expansion.

The Pay-off

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• In 2008, with copper prices spiking up, In 2008, with copper prices spiking up, the government of President Bachelet was the government of President Bachelet was under intense pressure to spend the revenue.under intense pressure to spend the revenue.– She & Fin.Min.Velasco held to the rule, saving most of it.She & Fin.Min.Velasco held to the rule, saving most of it.– Their popularity ratings reached historic lows.Their popularity ratings reached historic lows.

• When the recession hit and the copper price came When the recession hit and the copper price came back down, the government increased spending, back down, the government increased spending, mitigating the downturn.mitigating the downturn.– BacheletBachelet && Velasco’s popularity Velasco’s popularity

reached historic reached historic highshighs in 2009. in 2009.

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Three big themes of the last decadeThree big themes of the last decade

1.1. The importance of volatile-priced minerals The importance of volatile-priced minerals – and other commodities.and other commodities.

2.2. The importance of institutionsThe importance of institutions– e.g., for setting fiscal policy.e.g., for setting fiscal policy.

3.3. The importance of emerging market countriesThe importance of emerging market countries– as a possible new source of lessons,as a possible new source of lessons,– reversing the historic rolesreversing the historic roles– in which only advanced countries had been modelsin which only advanced countries had been models..

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Previously, fiscal policy tended to be Previously, fiscal policy tended to be procyclical in developing countries:procyclical in developing countries:

• Governments would raise spending in booms;Governments would raise spending in booms;

• and then be forced to cut back in downturns.and then be forced to cut back in downturns.• Kaminsky, Reinhart & Vegh Kaminsky, Reinhart & Vegh (2004),(2004), Talvi & Végh Talvi & Végh (2005),(2005),

Alesina, Campante & TabelliniAlesina, Campante & Tabellini ((2008),2008), Mendoza & Oviedo Mendoza & Oviedo (2006),(2006), Ilzetski & Vegh Ilzetski & Vegh (2008)(2008) and Medas & Zakharova and Medas & Zakharova (2009).(2009).

• Especially Latin American commodity-producersEspecially Latin American commodity-producers..• Gavin & Perotti Gavin & Perotti (1997),(1997), Calderón & Schmidt-Hebbel Calderón & Schmidt-Hebbel (2003)(2003) andand Perry Perry (2003).(2003).

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Kaminsky, Reinhart & Vegh (2004)

GG always used to be pro-cyclical always used to be pro-cyclical for most developing countries.for most developing countries.

Correlations between Gov.t Spending & GDPCorrelations between Gov.t Spending & GDP}pro

cyc

lica

lcou

nte

rcyc

lica

l

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The historic role reversalThe historic role reversal

• Over the last decade many emerging market countries Over the last decade many emerging market countries finally developed finally developed countercyclicalcountercyclical fiscal policies: fiscal policies:

• They took advantage of the boom years 2003-2008 They took advantage of the boom years 2003-2008 – to run budget primary to run budget primary surplusessurpluses..– By 2007, Latin America had reduced its debt to 33% of GDP, By 2007, Latin America had reduced its debt to 33% of GDP,

• as compared to 63 % in the United States. as compared to 63 % in the United States.

• Debt levelsDebt levels among top-20 rich countries among top-20 rich countries (debt/GDP ratios ≈ 80%) (debt/GDP ratios ≈ 80%)

are now twice those of the top-20 emerging marketsare now twice those of the top-20 emerging markets . .

• Some emerging markets have earned credit ratings Some emerging markets have earned credit ratings higher than some so-called advanced countries.higher than some so-called advanced countries.

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Ten econometric findingsTen econometric findingsregarding bias toward optimism regarding bias toward optimism

in official budget forecasts.in official budget forecasts.• Official forecasts of budgets & GDP in a sample Official forecasts of budgets & GDP in a sample

of 33 countries are overly optimistic on average.of 33 countries are overly optimistic on average.• The bias toward optimism is:The bias toward optimism is:

– stronger the longer the forecast horizon.stronger the longer the forecast horizon.

– greater among European governments greater among European governments that are under the budget rules in the SGP.that are under the budget rules in the SGP.

– greater at the extremes of the business cycle,greater at the extremes of the business cycle,• particularly in booms.particularly in booms.

• The key macroeconomic input for budget forecasting in The key macroeconomic input for budget forecasting in most countries: GDP. In Chile: the copper price.most countries: GDP. In Chile: the copper price.

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10 econometric findings regarding bias toward 10 econometric findings regarding bias toward optimism in official budget forecasts, optimism in official budget forecasts, continued.continued.

• Real copper prices mean-revert in the long run, Real copper prices mean-revert in the long run, – but this is not always readily perceived. but this is not always readily perceived.

– A mere 30 years of data cannot reject a random walk.A mere 30 years of data cannot reject a random walk.

• Uncertainty Uncertainty (option-implied volatility)(option-implied volatility) is higher when is higher when copper prices are toward the top of the cycle.copper prices are toward the top of the cycle.

• Chile’s official forecasts are not overly optimistic.Chile’s official forecasts are not overly optimistic.

• Chile has apparently avoided the problem of official Chile has apparently avoided the problem of official forecasts that unrealistically extrapolate in boom times.forecasts that unrealistically extrapolate in boom times.

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Official forecasts of budgets & GDP are Official forecasts of budgets & GDP are overly optimistic on averageoverly optimistic on average

in a sample of 33 countriesin a sample of 33 countries • (1)(1) Government forecasts of the Government forecasts of the budget balancebudget balance (App. Table 1)(App. Table 1)

– The average across all countries is an upward bias ofThe average across all countries is an upward bias of : :

• 0.2% of GDP at the 1-year horizon, 0.2% of GDP at the 1-year horizon,

• 0.8% of GDP 2 years ahead, 0.8% of GDP 2 years ahead,

• and a hefty 1.5% at 3 years ahead. and a hefty 1.5% at 3 years ahead.

• (2)(2) Government forecasts of the Government forecasts of the GDP growth rateGDP growth rate (App.Table 2)(App.Table 2)

– The average across all countries is an upward bias ofThe average across all countries is an upward bias of ::

• 0.4 % when looking 1 year ahead, 0.4 % when looking 1 year ahead,

• 1.1 % at the 2-year horizon, 1.1 % at the 2-year horizon,

• and 1.8% at 3 years. and 1.8% at 3 years.

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• The bias appears in the US & other advanced countries, The bias appears in the US & other advanced countries, – not particularly in emerging markets. not particularly in emerging markets. – Chile on average Chile on average underunder-forecast its growth rate, -forecast its growth rate,

• by 0.8 % at the 1-year horizon. by 0.8 % at the 1-year horizon.

• The sample of 33 countriesThe sample of 33 countries::– 26 from Europe (26 from Europe (of which, 16 of which, 16 €€ members) members)– 1 other major advanced country 1 other major advanced country (US), and(US), and

– 3 advanced commodity-exporters 3 advanced commodity-exporters (Australia, Canada, & NZ), (Australia, Canada, & NZ),

– 3 middle-sized emerging market commodity-exporters 3 middle-sized emerging market commodity-exporters (Chile, Mexico & South Africa).(Chile, Mexico & South Africa).

– Getting data on official forecasts Getting data on official forecasts • is very hard for others in this last category. is very hard for others in this last category. • Easy for Europe.Easy for Europe.

Official forecasts are overly optimistic, Official forecasts are overly optimistic, continued continued

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(3) Chile’s Official Budget Forecasts (3) Chile’s Official Budget Forecasts

Are Not Prone to the Optimism Bias of Others’Are Not Prone to the Optimism Bias of Others’

Figure 8aFigure 8a

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Figure 8c: Budget Forecasts are more BiasedFigure 8c: Budget Forecasts are more Biased

(4) in Booms & (5) at Longer Horizons(4) in Booms & (5) at Longer Horizons

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Budget balance forecast error as % of GDP, Full dataset

(1) (2) (3)

One year ahead Two years ahead Three years ahead

GDP relative to trend

0.093***(0.019)

0.258***(0.040)

0.289***(0.063)

Constant 0.201 0.649*** 1.364***(0.197) (0.231) (0.348)

Observations 398 300 179Variable 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.

Official budget forecasts are biasedmore if GDP is currently high & especially at

longer horizons

33 countries

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Budget balance forecast error as a % of GDP, Full Dataset(1) (2) (3) (4)

One year ahead

Two years ahead

One year ahead

Two years ahead

SGPdummy 0.658 0.905** 0.407 0.276(0.398) (0.406) (0.355) (0.438)

SGP dummy * (GDP - trend)

0.189**(0.0828)

0.497***(0.107)

Constant 0.033 0.466* 0.033 0.466*(0.228) (0.248) (0.229) (0.249)

Observations 399 300 398 300

(6) Official budget forecasts are more optimistically biasedin countries subject to a budget deficit rule (SGP)

*** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country.

33 countries

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• (7) The key macroeconomic input for forecasting (7) The key macroeconomic input for forecasting budget balance in most countries: GDP. budget balance in most countries: GDP.

• In Chile: the copper price.In Chile: the copper price.

• (8) Real copper prices mean-revert in the long run, (8) Real copper prices mean-revert in the long run, – but this is not always readily perceived. but this is not always readily perceived. – A mere 30 years of data cannot reject a random walk.A mere 30 years of data cannot reject a random walk.

• (9) Uncertainty (9) Uncertainty (option-implied volatility)(option-implied volatility) is higher is higher when copper prices are toward the top of the cycle.when copper prices are toward the top of the cycle.

• (10) But forecasts do internalize reversion to trend.(10) But forecasts do internalize reversion to trend.

Budget forecasting is not Budget forecasting is not easyeasy

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Table 6b

GDP & inflation as determinants of budget balance as a % of GDP, in 33 countries

(1) (2) (3)

VARIABLES 1 year ahead 2 years ahead 3 years ahead

GDP error 0.493*** 0.450*** 0.435***(0.054) (0.064) (0.075)

Inflation error 0.148 0.248** 0.301***(0.100) (0.110) (0.087)

Constant 0.359 0.675* 1.056**(0.235) (0.330) (0.385)

Observations 214 185 159

R2 0.35 0.40 0.35

RMSE 1.892 2.438 2.664

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Copper price as determinant of Chilean budget balance as % of GDP1990-2009 (20 observations)

 

  VARIABLES Coefficient estimates

 

  Copper forecast error 1/ 0.060** 0.056**  (0.021) (0.021)

  GDP growth error 0.239  (0.187)

  Constant -0.023 -0.163  (0.754) (0.683)

 

  R 2 0.299 0.251

  RMSE 2.655 2.666

* p<0.05. Robust standard errors in parentheses1.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

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

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Do copper prices random-Do copper prices random-walk?walk?

Or revert toward a long-Or revert toward a long-run? trendrun? trend

• 30 years of data cannot reject a random walk.30 years of data cannot reject a random walk.

• But, then, a priori calculations suggest But, then, a priori calculations suggest there is not enough power in 30 years of data there is not enough power in 30 years of data to find mean-reversion even if it is there.to find mean-reversion even if it is there.– One should need about 200 years of data.One should need about 200 years of data.

• (8)(8) Sure enough, copper prices revert to trend Sure enough, copper prices revert to trend– with statistical significance,with statistical significance,– when tested on 217 years of data (1784-2009);when tested on 217 years of data (1784-2009); – at an estimated speed of 0.13 per year at an estimated speed of 0.13 per year

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10 or 30 years of data are not10 or 30 years of data are not enough to discern enough to discern reversion of real price of copper to long-run trendreversion of real price of copper to long-run trend

Appendix Figure 1:Appendix Figure 1:

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226 years of data 226 years of data are are enough to discern enough to discern reversion of real price of copper to long-run reversion of real price of copper to long-run

trendtrendAppendix Figure 2:Appendix Figure 2:

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(9)(9) Uncertainty is genuinely Uncertainty is genuinely higher when the spot price higher when the spot price

is highis high

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Table 4: Uncertainty Is Greater When the Copper Price Table 4: Uncertainty Is Greater When the Copper Price is Above its Long-run Trendis Above its Long-run Trend

Regression of option-implied copper price volatility Regression of option-implied copper price volatility on log (real spot price) – linear trendon log (real spot price) – linear trend (log real spot price, using data for 230 years)(log real spot price, using data for 230 years)

(1) (2) (3) (4) (5)

VARIABLES 12 month 15 month 24 month 27 month 39 month

Real copper price (vs. LR trend)

7.34** 8.38*** 9.90*** 10.04*** 9.516***

(3.19) (3.02) (2.82) (2.77) (2.68)

Constant 29.19*** 27.74*** 24.88*** 24.32*** 23.42***(2.624) (2.489) (2.381) (2.353) (2.276)

Observations 60 60 60 60 59

*** p<0.01, ** p<0.05 Robust standard errors in parentheses

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Figure 4: Copper prices spot, forward, & forecastFigure 4: Copper prices spot, forward, & forecast 2001-20102001-2010

(10) Forecasts do internalize the tendency for copper prices to revert toward long-run equilibrium

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Table 3: Do private forecasters recognize mean reversion in copper prices?

(1) (2) (3)

VARIABLES logrealdiff15 logrealdiff27 logrealdiff63

Spot price real -0.00167*** -0.00291*** -0.00468***(0.00018) (0.00031) (0.00092)

Constant 0.0232*** 0.0405*** -0.0119(0.00697) (0.0116) (0.0466)

Observations 258 204 93

R2 0.147 0.232 0.186

RMSE 0.0631 0.0980 0.201

*** p<0.01 Robust standard errors in parenthesesLHS [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.

Yes

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ConclusionsConclusions

• Official growth & budget forecasts tend toward wishful thinkingOfficial growth & budget forecasts tend toward wishful thinking : : – unrealistic extrapolation of booms three years into the future. unrealistic extrapolation of booms three years into the future.

• The bias is worse among the European countries The bias is worse among the European countries supposedly subject to the budget rules of the SGP,supposedly subject to the budget rules of the SGP,– presumably because government forecasters feel pressured to be able to 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. 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 Chile is not subject to the same bias toward over-optimism in forecasts of the budget, growth, or the all-important copper price. forecasts of the budget, growth, or the all-important copper price.

• The key innovation that has allowed Chile The key innovation that has allowed Chile to achieve countercyclical fiscal policy:to achieve countercyclical fiscal policy:– not just a structural budget rule in itself, not just a structural budget rule in itself, – but rather the regime that entrusts to two panels of independent experts but rather the regime that entrusts to two panels of independent experts

estimation of the extent to which copper prices & GDP depart from their estimation of the extent to which copper prices & GDP depart from their long-run averages.long-run averages.

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Application to other countriesApplication to other countries

• Any country could adopt the Chilean mechanism,Any country could adopt the Chilean mechanism,– not just commodity-exporters.not just commodity-exporters.

• Suggestion: give the panels more institutional independenceSuggestion: give the panels more institutional independence– as is familiar from central banking:as is familiar from central banking:

• requirements for professional qualifications of the membersrequirements for professional qualifications of the members

• and laws protecting them from being fired.and laws protecting them from being fired.

• Two open questions:Two open questions:– Are the budget rules to be interpreted as ex ante or ex post?Are the budget rules to be interpreted as ex ante or ex post?

– How much of the structural budget calculations are How much of the structural budget calculations are to be delegated to the independent panels of experts?to be delegated to the independent panels of experts?

• The minimalist approach: The minimalist approach: they are mandated solely to compute 10-year moving averages.they are mandated solely to compute 10-year moving averages.

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AppendicesAppendices

1.1. The political success of the Chilean The political success of the Chilean government’s fiscal strategy, 2008-09government’s fiscal strategy, 2008-09

2.2. The Greek sovereign debt problem The Greek sovereign debt problem

3.3. Three big themes of the last decadeThree big themes of the last decade

4.4. What should US fiscal policy be now?What should US fiscal policy be now?

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Poll ratings of Chile’s President over time

Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009

In 2009, the popularity of the Socialist President of Chile Michelle Bacheletrose sharply (both with respect to handling of the economy and overall), to the highest levels since the restoration of democracy 20 years earlier.

More remarkable: the rise in the polls, from very low to very high, came just as the economy moved from rapid growth to slow growth -- not the usual pattern. Why?

Appendix 1: Chilean politics

44

And the Finance Minister?: August 2009

Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009

Poll ratings of Chile’s

Presidents and Finance

Ministers

In August 2009, the popularity of the Finance Minister, Andres Velasco,

ranked behind only President Bachelet, despite also having been low two years

before. Why?

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2. The Greek sovereign debt problem2. The Greek sovereign debt problem

Frankfurt & Brussels Frankfurt & Brussels made 3 mistakesmade 3 mistakes

• 2002-09: Did not allow spreads to open up 2002-09: Did not allow spreads to open up between sovereign debt of Greece & Germany.between sovereign debt of Greece & Germany.

• Winter 2010: Did not tell Greece to go to the IMF. Winter 2010: Did not tell Greece to go to the IMF. Preferred instead to “handle it internally.” Preferred instead to “handle it internally.”

• Still today: No “Plan B” to restructure Greek debt Still today: No “Plan B” to restructure Greek debt (and save the bailout fund for more deserving banks & PIIGs).(and save the bailout fund for more deserving banks & PIIGs).

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Judging from spreads, 2001-07, Judging from spreads, 2001-07, investors put zero odds on a default by Greece investors put zero odds on a default by Greece

or other Mediterranean countriesor other Mediterranean countries

Council on Foreign Relations

47

• Suddenly, in 2010, the Greek sovereign spread Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. shot up, exceeding 800% by June.

• Even when the Greek crisis erupted, Even when the Greek crisis erupted, leaders in Brussels & Frankfurt leaders in Brussels & Frankfurt seemed to view it as a black swan, seemed to view it as a black swan, – instead of recognizing it as a close cousin instead of recognizing it as a close cousin

of the Argentine crisis of ten years earlier, of the Argentine crisis of ten years earlier, • and many others in history,and many others in history,

– including among European countries.including among European countries.

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PredictionsPredictions

• Greece will have re-structure its debt.Greece will have re-structure its debt.

• The euro-zone will not break up.The euro-zone will not break up.– There is no legal provision for members to leave.There is no legal provision for members to leave.

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Sovereign debt worriesSovereign 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.

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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.

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Appendix 3: Appendix 3: Three big themes of the last decadeThree big themes of the last decade

1.1. The importance of volatile-priced minerals The importance of volatile-priced minerals – and other commodities.and other commodities.

2.2. The importance of institutionsThe importance of institutions– including for setting fiscal policy.including for setting fiscal policy.

3.3. The importance of emerging market countriesThe importance of emerging market countries– as a possible new source of lessons,as a possible new source of lessons,

– reversing the historic rolesreversing the historic roles

– in which advanced countries had been the modelsin which advanced countries had been the models• e.g., Japan in the 1980se.g., Japan in the 1980s

• And the US in the 1990s.And the US in the 1990s.

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Where to look for Where to look for lessons?lessons?

• Two decades ago, many had drawn a lesson from the 1980’s: Two decades ago, many had drawn a lesson from the 1980’s: Japan’s variant of capitalism was the best model, Japan’s variant of capitalism was the best model, – that other countries around the world should and would follow it. that other countries around the world should and would follow it.

– But the Japanese model quickly lost its luster in the 1990’s.But the Japanese model quickly lost its luster in the 1990’s.

• A decade ago, many thought that the lesson of the 1990’s was A decade ago, many thought that the lesson of the 1990’s was that the US variant of capitalism was the best model,that the US variant of capitalism was the best model,– that other countries should and would follow. that other countries should and would follow.

– The American model lost its attractiveness in the 2000’s.The American model lost its attractiveness in the 2000’s.

• So, where should countries look now, in 2010, So, where should countries look now, in 2010, for models of economic success to emulate?for models of economic success to emulate?

• Perhaps to the periphery of the world economy.Perhaps to the periphery of the world economy.

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Big lessons from small Big lessons from small countriescountries

• Some smaller and less-rich countries have experimented Some smaller and less-rich countries have experimented with policies & institutions that could usefully be adopted with policies & institutions that could usefully be adopted by some of the “advanced countries.” by some of the “advanced countries.”

• Two illustrations from microeconomics. Two illustrations from microeconomics.

– 11stst, Singapore pioneered the use of the price mechanism , Singapore pioneered the use of the price mechanism to reduce traffic congestion in its urban center. to reduce traffic congestion in its urban center.

• London emulated Singapore, successfully adopting congestion London emulated Singapore, successfully adopting congestion pricing in 2003; other big cities should do the same.pricing in 2003; other big cities should do the same.

– 22ndnd, Mexico pioneered Conditional Cash Transfer programs,, Mexico pioneered Conditional Cash Transfer programs,• making poverty benefits contingent making poverty benefits contingent on on children’s school attendance. children’s school attendance. • They have been emulated widely, embraced even in NYC.They have been emulated widely, embraced even in NYC.

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On On the larger theme that advanced economies the larger theme that advanced economies

could learn some things from developing countriescould learn some things from developing countries

• This line of argument is not meant as an attack This line of argument is not meant as an attack on Western values or modes of thought. on Western values or modes of thought.

• It is not a celebration of Confucian values It is not a celebration of Confucian values or native folk remedies in the Andes or Africa. or native folk remedies in the Andes or Africa.

• In my view, when Americans lectured others on the virtues In my view, when Americans lectured others on the virtues of fiscal discipline, market-based economics, the rule of of fiscal discipline, market-based economics, the rule of law, and electoral democracy, they were mostly right. law, and electoral democracy, they were mostly right.

• Where they were wrong:Where they were wrong:– the failure to see that their own country needed to be the failure to see that their own country needed to be

on the receiving end just as much as developing countries.on the receiving end just as much as developing countries.

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Advanced economies could learn some things Advanced economies could learn some things from developing countries,from developing countries, continuedcontinued

• Countries that are small, or newly independent, Countries that are small, or newly independent, or far-away, or emerging from a devastating war, or far-away, or emerging from a devastating war, are often more free to experiment, are often more free to experiment, – than is the US or other large established countries.than is the US or other large established countries.

• Not all the experiments will succeed. Not all the experiments will succeed.

• But some will. But some will.

• The results may include useful lessonsThe results may include useful lessons. .

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Advanced economies could learn some things Advanced economies could learn some things from developing countriesfrom developing countries, , continuedcontinued

• In some cases, Western institutions were successfully In some cases, Western institutions were successfully transplanted to other countries in the past, transplanted to other countries in the past, and now needed to be re-imported.and now needed to be re-imported.

• An analogy.An analogy. – In the latter part of the 19th century In the latter part of the 19th century

the vineyards of France were destroyed by the vineyards of France were destroyed by Phylloxera vastatrix, aPhylloxera vastatrix, a microscopic aphid. microscopic aphid.

– Eventually a desperate last resort was tried: Eventually a desperate last resort was tried: grafting susceptible European vines grafting susceptible European vines onto resistant American root stock.onto resistant American root stock.

– It saved the European vineyards. It saved the European vineyards. – The New World had come to the rescue of the Old.The New World had come to the rescue of the Old.

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The last decade has seen a historic reversal The last decade has seen a historic reversal in roles between advanced countries in roles between advanced countries and emerging/developing countries and emerging/developing countries

regarding fiscal policy.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.

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Appendix 4: Appendix 4: What should be What should be

the overall stance of US fiscal policy?the overall stance of US fiscal policy?

• Moving toward discipline in up-timesMoving toward discipline in up-times– 1993-2000. It did.1993-2000. It did.

– 2003-2007, It didn’t.2003-2007, It didn’t.

• Expansionary during down-timesExpansionary during down-times– 2010. It isn’t.2010. It isn’t.

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The US public discussion is framed like a battle between The US public discussion is framed like a battle between conservatives who philosophically believe in strong conservatives who philosophically believe in strong

budgets & small government, and liberals who do not. budgets & small government, and liberals who do not.

Not the right way to characterize the debateNot the right way to characterize the debate . . [1][1]

• (1) The right goal should be budgets that allow (1) The right goal should be budgets that allow surpluses in booms and deficits in recession.surpluses in booms and deficits in recession.

• (2) The correlation between how loudly an American (2) The correlation between how loudly an American politician proclaims a belief in fiscal conservatism politician proclaims a belief in fiscal conservatism and how likely he is to take corresponding policy steps and how likely he is to take corresponding policy steps < 0< 0..

[1][1] Forget that small government is classically supposed to be Forget that small government is classically supposed to be the aim of “liberals,” in the 19th century definition, not “conservatives.” the aim of “liberals,” in the 19th century definition, not “conservatives.” My point is different: those who call themselves conservatives in practice tend to 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.” adopt policies that are the opposite of fiscal conservatism. I call them “illiberal.” “Republican & Democratic Presidents Have Switched Economic Policies”“Republican & Democratic Presidents Have Switched Economic Policies”     Milken Milken Inst.RevInst.Rev.. 2003.2003.

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Three pieces of evidence to support the claim Three pieces of evidence to support the claim that “fiscal conservatives” are not:that “fiscal conservatives” are not:

• (i(i) The voting pattern among the 258 Congressmen ) The voting pattern among the 258 Congressmen who signed an unconditional pledge not to raise taxes:who signed an unconditional pledge not to raise taxes:– As of 2004, they had voted for more spending As of 2004, they had voted for more spending

than those who did not sign the pledge. than those who did not sign the pledge. [2][2]

• (ii) The pattern of spending (ii) The pattern of spending under Republican presidents.under Republican presidents.[3][3]

• (iii) The pattern of states whose Senators win pork (iii) The pattern of states whose Senators win pork & other federal spending.& other federal spending. [4][4]

• [2][2] William Gale & Brennan Kelly, 2004, “William Gale & Brennan Kelly, 2004, “The ‘No New Taxes’ PledgeThe ‘No New Taxes’ Pledge,” ,” Tax NotesTax Notes, July, July.. • [3][3] JF JF “Snake-Oil Tax Cuts,“Snake-Oil Tax Cuts,” ”   EPIEPI, , Briefing Paper 221Briefing Paper 221. 2008. . 2008. • [4] [4] JF JF Red States, Blue States and the Distribution of Federal SpendingRed States, Blue States and the Distribution of Federal Spending, 3/31/2010., 3/31/2010.

61

Vs. the 1990s: The Shared Sacrifice approach succeeded in Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spendingeliminating budget deficits, importantly by slowing spending. .

-3

-1

1

3

5

7

9

11

13

15

10

12

14

16

18

20

22

24

19

77

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

Est

20

09

Est

20

10

Est

Spending and Budget Balance(inverse) as % of GDP (Current US$)

Spending/GDP Budget Balance/GDP

R. R

ea

ga

n

J. C

art

er

G.H

.W.

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sh

W.J

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G.W

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Source: OMB

ρ = 0.86

(ii) Spending & deficts both rose sharply when (ii) Spending & deficts both rose sharply when Presidents Reagan, Bush I, & Bush II took office.Presidents Reagan, Bush I, & Bush II took office.

62

(iii) States ranked by federal (iii) States ranked by federal spending receivedspending received

per tax dollar paid in 2005per tax dollar paid in 2005versus party vote ratio in preceding versus party vote ratio in preceding electionelection

Republican states take home Republican states take home significantly more federal $ significantly more federal $ (relative to taxes paid)(relative to taxes paid) than Democratic statesthan Democratic states

“red”states

“blue”states low inflow of US $

big inflow of US $

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U.S. fiscal policy in 2010-2011?U.S. fiscal policy in 2010-2011?• What changes in American fiscal policy What changes in American fiscal policy

would be desirable at the current juncture,would be desirable at the current juncture, – if politics were not an obstacle? if politics were not an obstacle?

• On the one hand, the economy is still weak. On the one hand, the economy is still weak. • On the other hand, the U.S. can’t wait until the recovery On the other hand, the U.S. can’t wait until the recovery

is complete to tackle the long run fiscal problem. is complete to tackle the long run fiscal problem.

• A two-part strategy:A two-part strategy:• Current steps to extend the fiscal stimulus, Current steps to extend the fiscal stimulus,

– designed to maximize bang for the buck.designed to maximize bang for the buck.

• Current steps to lock in future progress Current steps to lock in future progress back toward fiscal discipline in the long run.back toward fiscal discipline in the long run.

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U.S. fiscal policy in 2010-2011U.S. fiscal policy in 2010-2011, continued, continued

• Maximizing bang for the buck ≡ fiscal stimulus that Maximizing bang for the buck ≡ fiscal stimulus that gives the most demand per $ added to long-term debt.gives the most demand per $ added to long-term debt.

• Example that would Example that would minimizeminimize bang for the buck: bang for the buck: – proposal to make permanent the 2010 estate tax abolition . proposal to make permanent the 2010 estate tax abolition . – Almost as poorly targeted: proposal to prevent the Bush tax Almost as poorly targeted: proposal to prevent the Bush tax

cuts from expiring in 2011 for those households > $250,000. cuts from expiring in 2011 for those households > $250,000.

• If the stimulus has to take the form of tax cuts, If the stimulus has to take the form of tax cuts, then the best options are:then the best options are:– extending President Obama’s “Make Work Pay” tax cuts, extending President Obama’s “Make Work Pay” tax cuts, – fixing the Alternative Minimum Tax, and fixing the Alternative Minimum Tax, and – extending the Bush tax cuts for those households < $250,000. extending the Bush tax cuts for those households < $250,000. – Some business tax cuts could also give high bang for the buck. Some business tax cuts could also give high bang for the buck.

• such as temporary credits for investment or hiring.such as temporary credits for investment or hiring.

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U.S. fiscal policy in 2010-2011U.S. fiscal policy in 2010-2011, continued, continued

• But spending boosts demand more than tax cuts do, But spending boosts demand more than tax cuts do, – because the latter are partly saved.because the latter are partly saved.

• Extend elements of the Obama stimulus Extend elements of the Obama stimulus – such as infrastructure investment and such as infrastructure investment and – giving money to the states giving money to the states

• so that they don’t have to lay off teachers, policemen, so that they don’t have to lay off teachers, policemen, firemen, subway drivers & construction workers.firemen, subway drivers & construction workers.

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U.S. fiscal policy in 2010-2011U.S. fiscal policy in 2010-2011, continued, continued

• How does one take steps today How does one take steps today to lock in future fiscal consolidation? to lock in future fiscal consolidation?

– Not by raising taxes or cutting spending today Not by raising taxes or cutting spending today (see above); (see above);

– nor by promising to do so in a year or two nor by promising to do so in a year or two (not credible).(not credible).

– There are lots of economically sensible proposalsThere are lots of economically sensible proposals

• for spending to eliminate, for spending to eliminate,

• more efficient taxes to switch to, more efficient taxes to switch to,

• and “tax expenditures” to cut. and “tax expenditures” to cut.

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U.S. fiscal policy in 2010-2011U.S. fiscal policy in 2010-2011, continued, continued

• One big reform might work best: One big reform might work best: pass legislation today to put Social Security pass legislation today to put Social Security on a sound financial footing in the long term. on a sound financial footing in the long term.

• It would consist of a combination It would consist of a combination – of raising the retirement age of raising the retirement age

• just a little (in proportion to lengthening life spans) just a little (in proportion to lengthening life spans)

– and slowing the growth of benefits for future retirees and slowing the growth of benefits for future retirees • just a little (perhaps by “progressive indexation). just a little (perhaps by “progressive indexation).

• If Washington could fix Social Security, If Washington could fix Social Security, – it would address the long-term fiscal outlook,it would address the long-term fiscal outlook,

– yet would create no drag for the current fragile recoveryyet would create no drag for the current fragile recovery..