Targeting the Structural BalanceLaura Dos Reis, Paolo Manasse and Ugo Panizza

XXIV Meeting of the Latin American Network of

Central Banks and Finance Ministries

Inter-American Development Bank

Washington, DC, October 19, 2006

Motivation

• Should a country adopt a target for fiscal policy?

• Should “fiscal rules” be used?

• Should they target a structural balance?

Outline

• The Cyclically Adjusted Balance: Definition, Interpretation and Implementation

• The Case for a Structural Balance Target: Deficit Bias, Procyclicality

• The Case for Discretionary Fiscal Policy: Virtuous Politicians, Creative Accounting, Irrelevance

The Cyclically Adjusted Balance

• Definition:– What part in the changes in the fiscal stance is due to

changes in the environment and what part to changes in policy?

• Five possible interpretations (Blanchard, 1990)1. Index of discretionary fiscal policy 2. Index of permanent (“structural”) fiscal stance3. Index of how fiscal policy affects the economy4. Index of fiscal sustainability5. Policy target

Problems of Interpretation

• CAB as a measure of discretionary fiscal policy => active vs. passive

• CAB as a measure of “structural” policy stance => temporary vs. permanent shocks

• CAB as an indicator of the impact of fiscal shocks on the economy => balanced budget multiplier

• CAB as an indicator of fiscal sustainability => real interest rate, rate of growth, debt structure

• CAB as policy target : => optimal level of public savings? Let automatic stabilizer operate?

Problems of Computation

• Decomposition between trend and cycle– The detrending method matters– “Forward looking filters” require future data– Data revisions affect the decomposition

Data revision and CAB for Brazil

Figure 1: 1990 Brazil’s Output Gap Measured in Different Periods

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Year of measurement

Ou

tpu

t G

ap in

199

0 (%

of

Pot

enti

al o

utp

ut)

Impact of GDP Revisions on CABs: Spring 2003 vs. Autumn 2003 EC Release

Revision to GDP Growth Rates

(percentage points)

Elasticity of

Balance to Cycle

Revisions to CABs

(percentage points of GDP)

2001 2002 2003 2004 2001 2002 2003 2004 2005

Austria 0.1 0.3 -0.2 -0.1 0.3 0.00 0.02 0.05 0.08 0.12

Belgium -0.1 0.0 -0.4 -0.5 0.6 -0.16 -0.20 -0.24 -0.26 -0.26

Finland 0.6 0.6 -0.8 -0.4 0.7 -0.04 -0.09 -0.17 -0.29 -0.45

France 0.3 0.1 -1.1 -0.6 0.4 -0.08 -0.15 -0.23 -0.31 -0.39

Germany 0.3 0.0 -0.4 -0.4 0.5 0.00 -0.02 -0.04 -0.07 -0.08

Greece 0.0 -0.2 0.4 0.4 0.4 0.04 0.08 0.13 0.18 0.23

Ireland 0.5 0.9 -1.8 -0.8 0.4 0.06 -0.06 -0.24 -0.49 -0.78

Italy 0.0 0.0 -0.6 -0.6 0.5 -0.11 -0.19 -0.29 -0.40 -0.53

Luxembourg 0.1 0.9 0.1 -0.8 0.6 0.95 1.08 1.15 1.18 1.16

Portugal 0.0 0.0 -1.3 -1.1 0.4 -0.18 -0.31 -0.48 -0.66 -0.85

Spain 0.2 0.0 0.3 -0.2 0.4 0.08 0.08 0.18 0.25 0.32

The Netherlands 0.0 -0.1 -1.4 -1.1 0.7 -0.31 -0.52 -0.78 -1.06 -1.33

Average absolute

revision

0.2 0.3 0.7 0.6 0.17 0.24 0.33 0.44 0.54

Problems of Computation

• Decomposition between trend and cycle– Output = Trend + Cycle– What detrending method should be used?– Most “filters” (HP) need future data– Data revisions affect the decomposition– Things are even more complicated in EM

countries where it is not clear what is the trend and what is the cycle (Aguiar and Gopinath, 2004)

Problems of Computation

• Estimate Revenue & Expenditure elasticities to output => Balance elasticity

- Information on the source of change in the balance

- But not directly relevant for the question of CAB

- Estimation errors?

Outline

• The Cyclically Adjusted Balance

• The Case for a Structural Balance Target

• The Case for Discretionary Fiscal Policy

The Case for Structural Balance

• A fiscal rule can reduce the deficit bias of myopic politicians– However a simple fiscal rule can lead to

procyclicality (tradeoff credibility stabilization)

• A fiscal rule defined in terms of a CAB can reduce deficit bias while allowing for the conduct of countercyclical fiscal policy

The Case for Structural Balance

• Procyclicality– First documented by Gavin and Perotti (1997) and then

corroborated by several others– Also present in industrial countries but only during

good times– Possible explanations

• Poor institutions• Procyclical capital flows• Rules?

– Evidence that fiscal rules reduce the deficit bias and also procyclicality

The Case for Structural BalanceFiscal Rules, Deficit Bias and Procyclical PolicyDependent Variable: Primary surplus/GDP

Outline

• The Cyclically Adjusted Balance

• The Case for a Structural Balance Target

• The Case for Discretionary Fiscal Policy

The Case for Discretion

• Unnecessary constraints to virtuous politicians– When institutional quality is controlled for, fiscal rules

do not matter anymore (Manasse (2006))

– So rules maybe endogenous

– Useless but not harmful: they may even give some ammunition to a virtuous policy-maker

– However, a CAB rule may force a virtuous politicians to spend too much if people think that trend growth has increased

The Case for Discretion

• Creative accounting– Rules may create incentives for creative

accounting– The incentive for creative accounting may be

reduced or raised by a simpler (i.e unadjusted balance based) rule

• More difficult to trick the data

• More incentive to trick the data

The Case for Discretion

• Setting limit on deficits may not suffice for preventing debt explosions– Change in Debt = Deficit+ Stock-Flow Adj– SF is huge (creative accounting may be part of

this, see Campos, Jaimovich, and Panizza 2006)

Contribution to debt growth of extra-budgetary items (balance-sheet effects,

skeletons, etc.)

-2

0

2

4

6

8

10

12

14

16

18

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Per

cent

of

GD

P

Simple average for: Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela

The Case for Discretion

• Procyclicality might be less important than previously thought– Reverse causality: fiscal expansion causes a

boom (and not vice versa), see Rigobon, 2004, Jaimovich and Panizza, 2006)

Issues for Discussion

• Can CAB rules play a useful role or do they impose unnecessary constraints?

• Can EMs confidently estimate trend and cyclical output?

• Is creative accounting an issue?• Are independent fiscal councils a good idea?

– To prepare non-forecast for revenues and growth– Can decision of the size of the budget balance be

delegated to an independent authority?

Issues for Discussion

• Even if CAB rules can play a useful role, implementing such rules is the best way to spend scarce political capital?

• Is the sequencing important? Should more modest budget reforms (transparency, hierarchical rules, FRL) come first?