Fiscal Policy Rules and Latin America: Lessons from the Crisis

With the exception of Mexico, many large Latin American economies have shown a respectable resilience to the global financial crisis. The most recent information suggests that growth will be positive for the region in the second half of the current year, faring better than initially expected. This is definitely surprising given that Latin America depends heavily on the developed world, mostly through trade and capital flows.

Fiscal policy has been mentioned as a key driver of this surprising performance. Prior to the present crisis, and unlike previous crises, several Latin American countries had moderate fiscal deficits or, in some cases, surpluses. The resulting lower public debt to GDP ratios was instrumental in allowing governments to use fiscal policy to ameliorate the effects of the shock without compromising market confidence and access to international financial markets.

Among the countries in the region, Chile has been mentioned as the paradigmatic example of prudent fiscal management using a balanced structural budget (BSB) as a target for fiscal policy. Many, President Obama included, have celebrated Chile’s countercyclical fiscal policy during the crisis, and countries like Germany have even taken steps to formally adopt a similar framework.

From a methodological point of view, the structural balance removes the cyclical or transitory components of revenues and expenditures (thus isolating the structural components) included in the traditional balance. In the case of Chile, apart from controlling the ups and downs in revenues that result from the business cycle, the procedure isolates the variations in the price of copper from its long-run projection. Proceeds from privatizations are also excluded from the structural measure. In other words, the structural budget reflects what the fiscal budget would have been had the economy been on its medium-term trend. Using a (balanced) structural budget objective also implies that fiscal policy operates as an automatic stabilizer: whenever the economy is below its medium-term trajectory there will be an observed fiscal deficit while the structural measure remains stable.

Say that fiscal revenues increase from their medium-term trend. If there no cyclical adjustment to fiscal expenditures, as is the case in Chile, this implies that fiscal expenditures will remain stable in order to keep a balanced structural budget. As a result we have a balanced structural budget but a surplus according to the traditional cash-flow budget. The government accumulates assets that are then used when fiscal revenues are below their trend value. In this case, the government maintains fiscal expenditures stable (equal to the structural level of revenues) and the result is then a balanced structural budget and a fiscal deficit. Note that the mechanism does not require pre-existing assets: As long as these are credible and sustainable policies, investors should believe that there shall be money to pay them back.

This is simple, but yet different from the way fiscal policy has traditionally worked in Latin America.

Such a rule requires discipline: governments should resist temptations to spend, while safely investing the savings. Political considerations make these decisions difficult to implement in some countries. Incumbents typically do not want to leave resources for someone else to benefit politically, while special interest groups put pressure on the government to spend those resources. To deal with these issues, countries–like Chile–have institutionalized some rules.

The rules require accountability and periodic reviews of the budget and the overall fiscal policy stance. A non-partisan committee of experts is one alternative if the annual discussion of the budget law does not provide enough comfort. But well a designed oversight mechanism, clearly established by law, is indispensable. Furthermore, a balanced budget rule works only when the standard solvency and credibility conditions are met. If credibility is lacking, countries may need additional restrictions to limit expenditures whenever they can jeopardize the structural balance objective. But the design should also strike a delicate balance: if the rule ends up being too tight they will not give space to use the resources during slowdowns, undermining its effectiveness as a countercyclical device.

In developed countries, certain government programs, such as unemployment insurance, cause public expenditures to automatically increase during slowdowns. The design of a fiscal policy rule in emerging countries can incorporate a similar mechanism. For example, a balanced structural budget rule can accommodate a social spending program that is activated when certain conditions are met. Depending on the characteristics of the country, this program can include transitory unemployment insurance payments, subsidies for on-the-job training programs, and/or conditional cash transfers to prequalified households. The resulting increases in expenditures can play a countercyclical role, reinforcing the role of standard automatic stabilizers. Ideally, these programs should be designed in advance and triggered by some previously determined criteria (like a certain level of unemployment) or by a politically independent entity. It might be necessary for developing countries to build up enough credibility before doing it. It is a nice graduation prize.

Fiscal rules that generate countercyclical fiscal policy do not guarantee macroeconomic stability. While they provide a framework that can help governments have more space to use fiscal policy when needed, business cycles have multiple causes and consequences and fiscal policy alone cannot offset them entirely.

Finally, these rules do not solve other fiscal problems, such as determining the optimal level of expenditures or taxes. A comprehensive fiscal strategy cannot focus solely on the short- and medium-term evolution of fiscal policy, but should also focus on longer-term development strategies. Policies and initiatives aimed at reducing tax evasion and improving the efficiency of the public sector are essential components of a broad strategy to improve fiscal capacity and performance in Latin America.