Transcript Fiscal - Harvard Kennedy School

Institutions of Macroeconomic Policy
Jeffrey Frankel
Harpel Professor
Advanced Workshop on Global Political Economy
Institute for Global Law & Policy, Harvard Law School
Lecture II, May 31, 2012
Fiscal Policy Institutions
• Lessons from small country institutions?
• Proper role of the government
• Some political economy models
– The political budget cycle
– Procyclical government spending
– Emerging markets & the historic role reversal.
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• Appendices
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The U.S. fiscal situation
Some important macro relationships
“Fiscal conservatives”
The long-term US debt problem
US fiscal stimulus in 2013
The bias in official forecasts
Where can countries look
for policies and institutions to emulate?
• In the past, some considered
the great powers worthy of emulation:
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UK in the 19th century;
USSR after 1917;
Japan in the 1980s;
US in the 1990s.
• But each model was subsequently dis-credited.
Advanced economies could learn some things
from small & developing countries
• Countries that are small, or newly independent,
or far-away, or emerging from a devastating war,
are often more free to experiment with new
policies and institutions,
– than is the US or other large established countries.
• Not all the experiments will succeed.
• But some will.
• The results may include useful lessons.
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A few examples of specific institutional innovations
from the periphery worth emulating
• Singapore:
i) paternalistic approach to saving
ii) price mechanism to defeat
urban traffic congestion
• Costa Rica & Mauritius:
no standing army.
• Mexico:
1) non-partisan federal
electoral institutions
• 2) Conditional Cash Transfers
• Mexico:
hedging oil export revenues
by means of options
• Chile:
structural budget institutions
• Botswana:
independently managed
Sovereign Wealth Fund
(OPORTUNIDADES)
"What Small Countries Can Teach the World," Business Economics , April 2012.
“Some Big Ideas from Small Countries,” European Financial Review, May 2011.
Advanced economies could learn some things
from developing countries
• Some Western institutions were successfully
transplanted to other countries in the past,
and versions 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, a microscopic 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.
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Proper role of the public sector:
How big should the government be?
• Regulation vs. budget policy
• Market failures:
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externalities and public goods,
monopoly and collusion,
imperfect information and missing markets,
income distribution.
• Government failures:
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no access to decentralized information,
regulatory capture,
desire for re-election => pandering & short horizons,
rent-seeking, corruption, etc.
Proper role of the public sector,
• Public finance functions:
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sectoral allocation
income distribution
social insurance
macroeconomics.
• Macroeconomic time frames:
– long-run growth
– cyclical stabilization
– short-run crisis stabilization.
cont.
Some political economy models
• Rent-seeking:
lobbying, regulatory capture, corruption
• Mancur Olson’s logic of collective action:
getting together to oppose a well-organized lobby
of a few producers is not worth the cost,
to many small consumers.
• “Starve the Beast”: tax  => BD  => G 
(This is a political economy theory that fails.)
Some political economy models, continued
• The political budget cycle
• Pro-cyclical fiscal policy
• Institutions to constrain excessive
government spending in boom times.
Destabilizing fiscal policy
• In the textbook approach, benevolent governments
are supposed use discretionary fiscal (& monetary)
policy counter-cyclically: to dampen cyclical fluctuations
• expanding at times of excess supply, and
• contracting at times of excess demand.
• In practice, policy has often been destabilizing,
particularly in developing countries.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Political economy explanations
for destabilizing fiscal policy
• #1 : Political Budget Cycles
– Politicians expand just before elections, so that
rapid growth will buy votes; the cost comes later
(debt, inflation, reserve loss, devaluation).
– Example: The Mexican sexenio (until 2000)
– Do politicians really fool voters this way?
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Political budget cycles
• were thought to pertain to less developed economies.
• But they turn out to have been a phenomenon of
“new democracies” per se [e.g., Central Europe],
• where fiscal manipulation may be effective because
of lack of experience with electoral politics.
• It appears that politicians on average fool
voters roughly in the first 4 elections held.
• A.Drazen & A.Brender, 2005, JME,
"Political Budget Cycles in New versus Established Democracies."
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Can you get a political budget cycle
even if voters & politicians are fully rational?
Yes.
Officials seek to convince voters
that they are competent economic managers,
by keeping taxes low before the election.
They gamble on things turning out okay later.
Kenneth Rogoff, AER, 1990, “Equilibrium Political Budget Cycles”
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Political economy explanations
for destabilizing fiscal policy
• #2: Procyclical government spending
– Due, e.g., to commodity cycle
• Dutch Disease in commodity booms,
• and the need to retrench in downturns.
– Bias toward optimism in official forecasts
• especially in boom times,
• allowing procrastination in fiscal retrenchment.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Historically, fiscal policy has been procyclical
in developing countries:
• Governments would raise spending in booms;
• and then be forced to cut back in downturns.
• So the correlation between spending &GDP was negative.
• Especially
– among commodity-producers
– in Latin America.
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Correlations between Govt. Spending & GDP
1960-1999
Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”
procyclical
Pro-cyclical spending
countercyclical
Countercyclical
spending
G always used to be pro-cyclical
for most developing countries.
The historic role reversal
• Debt levels among rich countries (debt/GDP ratios ≈ 80%)
are now twice those of emerging markets
– and rising rapidly..
• Some emerging markets have earned credit ratings
higher than some so-called advanced countries.
• Over the last decade some emerging market countries
finally developed countercyclical fiscal policies:
• They took advantage of the boom years 2003-2007
– to run budget primary surpluses and cumulate reserves.
– By 2007, Latin America had reduced its debt to 33% of GDP,
• as compared to 63 % in the United States.
– And so were able to respond to global recession of 2008-09 .
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Ratio of public debt to GDP among advanced countries
is the highest since the end of WW II
Source: Carlo Cotarelli “Making Goldilocks Happy,” IMF, Apr. 20, 2012
Country creditworthiness is now inter-shuffled
“Advanced” countries
AAA Germany, UK
AA+ US, France
AA
Belgium
AA- Japan
A+
A
ABBB+ Ireland, Italy, Spain
BBB- Iceland
BB+
BB
Portugal
B
SD
Greece
(Formerly) “Developing” countries
Singapore, Hong Kong
Chile
China
Korea
Malaysia, South Africa
Brazil, Thailand, Botswana
Colombia, India
Indonesia, Philippines
Costa Rica, Jordan
Burkina Faso
S&P ratings, Feb.2012 updated 4/25/2012
Correlations between Govt. Spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2012)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
Countries with good institutional quality tend
to be the ones that have attained countercyclical fiscal policy
Frankel, Vegh & Vuletin (2012)
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Wishful Thinking
Some new econometric findings on a bias toward optimism
in official budget forecasts among 33 countries
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• Official growth & budget forecasts
tend toward wishful thinking:
– unrealistic extrapolation of booms, especially 3 years into the future.
• The gap between the projected budget balance
and the realized balance, on average:
• 0.2% of GDP at the 1-year horizon,
• 0.8 % at the 2-year horizon, and
• 1.5 % at the 3-year horizon.
• Optimistic forecasts allow procrastinated fiscal retrenchment.
Frankel, “Over-Optimism in Forecasts by Official Budget Agencies and Its Implications.” in Oxford Review of Economic Policy.2011 .
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Optimism bias in official forecasts, continued
• Fiscal rules are the current fashion. Do they help?
• The forecast bias is worse among the EU countries
supposedly subject to the budget rules of the SGP,
– presumably because government forecasters feel pressure to announce
they are on track to meet budget targets even if they are not.
– When euro country deficits strayed above the 3% GDP limit,
governments would adjust their forecasts, but not their policies.
• Example: The Greek government projected
in 2000 that its budget deficit would shrink
– below 2% of GDP one year in the future and
– below 1% of GDP two years into the future, and
– that it would swing to surplus 3 years into the future.
• The actual deficit: 4-5% of GDP, well above the 3%-of-GDP ceiling.
Even though true Greek budget deficits in most years
were far in excess of the supposed limit (3% of GDP),
the official budget forecasts were always rosy.
Until, in 2009, the bottom fell out of the budget.
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Source: Frankel & Schreger (2011)
Econometric findings on a bias in official budget forecasts, continued
Frankel, 2012 , “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” Central Bank of Chile
• 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.
• The result is that Chile was able to save the revenue
during the copper boom that peaked in 2008
– and so had the space to spend in 2009, moderating the downturn.
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What determines countries’ fiscal performance?
• Fundamentally: Quality of institutions.
– This does not mean “tough” rules, if they lack enforceability
• like U.S. debt ceiling or Balanced Budget Amendment;
• or Stability & Growth Pact or revised Fiscal compact.
– Better would be structural budget targets (Swiss)
with forecasts from independent experts (Chile).
• The smartest commodity exporters save earnings
in a Sovereign Wealth Fund (Norway, Botswana)
– Some EM countries have graduated from pro-cyclical
spending to countercyclical since 2000.
– The US, UK & euro countries
could learn from them.
End of Lecture II
Fiscal Policy Institutions
Jeffrey Frankel
James W. Harpel Professor of Capital Formation & Growth
http://ksghome.harvard.edu/~jfrankel/
Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/
Appendices
• The U.S. fiscal situation
– The standoff
– How to reduce the deficit
•
•
•
•
•
Some important macro relationships
“Fiscal conservatives”
The long-term US debt problem
US fiscal stimulus in 2013
The bias in official forecasts
• Chile’s structural budget rule