Transcript Appendix on fiscal procyclicality

Appendix to L24:
Failures of Fiscal Policy,
Creditworthiness & Cyclicality
• Procyclical fiscal policy
• Industrialized vs. developing countries
• Historic role reversal (2000-2011) ?
• The political budget cycle
• The commodity cycle
• Optimism bias in official budget forecasts
• Institutional fix: The case of Chile
The historic role reversal
• 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 2003-2008
– 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
.
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Country risk ratings, S&P 2011
Advanced countries
Country
Rating
Former developing countries Developing countries
Country
Rating
Country
Rating
Canada
AAA
Singapore
AAA
Germany
AAA
Hong Kong
AAA
United States
AA+
Belgium
AA
Taiwan
AA-
China
AA-
Japan
AA-
Chile
A+
Botswana
A-
Spain
AA-
Malaysia
A-
Italy
A
Thailand
BBB+
S. Africa
BBB+
Brazil
BBB
South Korea
A
Portugal
BBB-
Peru
BBB
Iceland
BBB-
India
BBB-
Indonesia
BB+
Nigeria
B+
Greece
CC
Pro-cyclical fiscal policy
THESE 3 PAGES WERE IN L3 APP. IN 2010
• In the textbook approach, benevolent governments
are supposed use discretionary fiscal (& monetary)
policy to dampen cyclical fluctuations.
• expanding at times of excess supply, and
• contracting at times of excess demand.
• In practice, policy has often been procyclical,
i.e., destabilizing, 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
Historic role reversal in the cyclicality of fiscal
policy in industrialized vs. developing countries
Previously, fiscal policy was procyclical
in 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).
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Correlations between Gov.t Spending & GDP
1960-1999
Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”
procyclical
Pro-cyclical spending
countercyclicall
Countercyclical
spending
G always used to be pro-cyclical
for most developing countries.
The procyclicality of fiscal policy, cont.
• An important development -some developing countries, including
commodity producers, were able to break
the historic pattern in the most recent decade:
– taking advantage of the boom of 2002-2008
• to run budget surpluses & build reserves,
– thereby earning the ability to expand
fiscally in the 2008-09 crisis.
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Correlations between Government spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2011)
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 (2011)
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?
• #2: Procyclical government spending
– Due, e.g., to commodity cycle
• Dutch Disease in commodity booms,
• and the need to retrench in downturns.
– New: Optimism bias in official forecasts
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
A.Drazen & A.Brender, "Political Budget Cycles in
New versus Established Democracies," JME, 2005.
Summary: Political budget cycles were once thought
a phenomenon of 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 or
lack of the sort of information that voters
in more established democracies use.
• It appears that politicians can and do on average
fool voters roughly in the first 4 elections held.
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 rationale? Yes.
Rogoff (1990): officials seek to signal to voters
that they are competent economic managers,
by keeping taxes low before the election.
• Kenneth Rogoff, 1990, “Equilibrium Political Budget Cycles,”
American Economic Review, 80(1), pp. 21-36.
• Torsten Persson & Guido Tabellini, 2002, “Political Economics
and Public Finance,” Handbook of Public Economics, Vol.3, pp.1549-1659.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Some new econometric findings on a bias toward optimism
in official budget forecasts among 33 countries
Frankel, 2011, “Over-Optimism in Forecasts by Official Budget Agencies and Its Implications.” forthcoming in Oxford Review of Economic Policy. NBER Working Paper 17239.
-------, 2011, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” Central Bank of Chile. NBER WP 16945.
• Official growth & budget forecasts tend toward wishful thinking :
– unrealistic extrapolation of booms, especially 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 pressured
to 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 &13
GDP.
Addendum to the procylicality of fiscal policy:
More on optimism bias & the case of Chile
Ten econometric findings regarding bias toward
optimism in official budget forecasts.
Frankel, 2011, “Over-Optimism in Forecasts by Official Budget Agencies and Its Implications.” forthcoming in Oxford Review of Economic Policy. NBER Working Paper 17239.
-------, 2012, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” forthcoming, Series on Central Banking Analysis & Economic Policies (Central Bank of Chile), vol.17. NBER WP 16945.
•
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 in booms
Greater among governments
that are under budget rules (SGP).
Chile’s official forecasts are not overly optimistic.
–
Chile has apparently avoided the problem of official forecasts
that unrealistically extrapolate in boom times.
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10 econometric findings regarding bias toward
optimism in official budget forecasts, continued.
•
The key macroeconomic input for budget forecasting in
most countries: GDP.
In Chile: the copper price.
•
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.
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Official forecasts of budgets & GDP are
overly optimistic on average
in 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
– The average across all countries is an upward bias of:
• 0.4 % when looking 1 year ahead,
• 1.1 % at the 2-year horizon,
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• and 1.8% at 3 years.
(App.Table 2)
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.
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Official budget forecasts are biased
more if GDP is currently high & especially at longer horizons
Budget balance forecast error
33 countries
as % of GDP, Full dataset
(1)
(2)
(3)
One year ahead
Two years ahead
Three years
ahead
0.093***
0.258***
0.289***
(0.019)
(0.040)
(0.063)
0.201
0.649***
1.364***
(0.197)
(0.231)
(0.348)
GDP relative
to trend
Constant
Variable is lagged so that it lines
in which the forecast 179
was made.
Observations
398 up with the year 300
*** p<0.01
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Robust standard errors in parentheses, clustered by country.
(6) Official budget forecasts are more optimistically biased
in countries subject to a budget deficit rule (SGP)
Budget balance forecast error
33 countries
SGPdummy
(1)
(2)
(3)
(4)
One year
ahead
Two years
ahead
One year
ahead
Two years
ahead
0.658
0.905**
0.407
0.276
(0.398)
(0.406)
(0.355)
(0.438)
0.189**
0.497***
(0.0828)
(0.107)
SGP dummy *
(GDP - trend)
Constant
as a % of GDP, Full Dataset
0.033
0.466*
0.033
0.466*
(0.228)
(0.248)
(0.229)
(0.249)
300
398
300
Observations
399
*** p<0.01, ** p<0.05, * p<0.1
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Robust standard errors in parentheses, clustered by country.
Poll ratings of Chile’s
President over time
In 2009, the popularity of the Socialist President of Chile Michelle Bachelet
rose 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?
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
And the
Finance
Minister?:
August 2009
In August 2009, the
popularity of the
Finance Minister,
Andres Velasco,
ranked behind only
President Bachelet,
higher than any
other minister since
democracy. Why?
Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009
Chile’s structural budget rule
• Government must set a fiscal target:
– In booms, can only spend structural revenue,
• must save the cyclical component.
– Structural ≡ economy at full employment
& price of copper at its long-run level
– Under Bachelet, structural deficit target was 0.
• Estimates of structural vs. cyclical
are made by commissions of experts,
not politicians, which avoids wishful thinking.
– In other countries, official fiscal forecasts have optimism bias.
JF, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” 2011.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
In 2008, a copper price spike had looked permanent to many.
In 2009, the price reverted toward its long run trend.
Forecasts internalize the tendency
for copper prices to revert toward long-run equilibrium
Copper prices spot, forward, & forecast 2001-2010
spot price
official
forecast
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:
• laws protecting them from being fired.
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