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

2

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.

Country risk ratings, S&P 2011

Advanced countries Former developing countries Developing countriesCountry Rating 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  South Korea A  Thailand BBB+

 S. Africa BBB+

 Brazil BBB

 Portugal BBB-  Peru BBB

 Iceland BBB-  India BBB-

 Indonesia BB+

 Greece CC  Nigeria B+

Copyright 2007 Jeffrey Frankel, unless otherwise notedAPI-120 - Macroeconomic Policy Analysis I

Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Pro-cyclical fiscal policyTHESE 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.

5

Historic role reversal in the cyclicality of fiscal policy in industrialized vs. developing countries

Previously, fiscal policy was procyclicalin 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).

Correlations between Gov.t Spending & GDP1960-1999

procyclical }

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

countercyclicall

Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”

Pro-cyclical spending

Counter-cyclical spending

77

• 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.

The procyclicality of fiscal policy,The procyclicality of fiscal policy, contcont..

Correlations between Government spending & GDP 2000-2009

In the last decade, about 1/3 developing countries

switched to countercyclical fiscal policy:Negative correlation of G & GDP.

Frankel, Vegh & Vuletin (2011)

procyclical

countercyclical

Countries with good institutional quality tend to be the ones that have attained countercyclical fiscal policy

Copyright 2007 Jeffrey Frankel, unless otherwise notedAPI-120 - Macroeconomic Policy Analysis I

Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Frankel, Vegh & Vuletin (2011)

Copyright 2007 Jeffrey Frankel, unless otherwise notedAPI-120 - Macroeconomic Policy Analysis I

Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise notedAPI-120 - Macroeconomic Policy Analysis I

Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

• #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

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 notedAPI-120 - Macroeconomic Policy Analysis I

Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise notedAPI-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 notedAPI-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.

13

Some new econometric findings on a bias toward optimismin 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 & GDP.

Addendum to the procylicality of fiscal policy:

More on optimism bias & the case of Chile

15

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.•

16

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.

17

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 (App.Table 2)

– The average across all countries is an upward bias of :• 0.4 % when looking 1 year ahead, • 1.1 % at the 2-year horizon, • and 1.8% at 3 years.

18

• 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.

Official forecasts are overly optimistic, continued

19

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 Robust standard errors in parentheses, clustered by country.

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

33 countries

20

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

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 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?

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,

higher than any other minister since democracy. Why?

Copyright 2007 Jeffrey Frankel, unless otherwise notedAPI-120 - Macroeconomic Policy Analysis I

Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

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.

In 2008, a copper price spike had looked permanent to many.In 2009, the price reverted toward its long run trend.

Copper prices spot, forward, & forecast 2001-2010

Forecasts internalize the tendency for copper prices to revert toward long-run equilibrium

spot price

official forecast

26

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.