THE GREAT RECESSION, “RAINY DAY” FUNDS, AND COUNTERCYCLICAL FISCAL POLICY IN LATIN AMERICA

I. INTRODUCTION The current financial crisis has been the most severe and widespread that the international economy has experienced since the Great Depression of the 1930s. Although it originated in the United States, the crisis spread internationally very quickly. Developing countries in particular were affected through various channels, both financial and real. The financial channels include sharp contractions in domestic asset prices and capital outflows, while the real channels include reductions in export volumes, declines in the prices of primary commodities, and reduced flows of workers' remittances. The worldwide nature of the crisis has generated a debate both in each affected nation and in all the major international financial organizations about the appropriate nature of the policy response. The complicating factors in addressing this issue are that the crisis manifested itself in different forms in different countries, that the effectiveness of the policy instruments available to confront it is likely to differ country by country, that each country faces country-specific constraints and tradeoffs in deploying such policy instruments, and that countries differ in the weights that they place on different policy objectives. Not surprisingly, therefore, there has been much international disagreement about appropriate policy responses, and individual countries have implemented quite different policies. This article considers the challenge of crisis policy from the perspective of Latin America, Its particular concern is with the appropriate role for countercyclical fiscal policy in response to the crisis. This issue was hotly debated within the region in the early stages of the crisis, and prominent voices argued for fiscal restraint, for reasons similar to those used to justify fiscal restraint more recently in many countries outside the region--that is, to safeguard market confidence. In the event, breaking with the past, countries in Latin America indeed undertook moderate fiscal stimulus. Instead of engineering fiscal restraint, fiscal balances in 2009 were allowed to accommodate the downturn in almost every country in the region. (1) In the typical country, the primary fiscal balance in 2009 deteriorated with respect to 2008 by 2.4 points of gross domestic product (GDP), 1.4 points because of lower fiscal revenues, and 1 point on account of higher expenditures. Countercyclical fiscal policy was behind not only spending expansion but, in part, revenue contraction because of lowering taxes. This impulse is planned to continue to some extent over 2010. Recovery is currently under way in Latin America. Because there were other forces driving that recovery, however (such as fast-growing demand for the region's primary products from booming economies in Asia), the contribution of fiscal stimulus to the region's recovery remains to be established. However, the question remains: was countercyclical fiscal policy an ex ante mistake that proved to be less harmful ex post because of fortunate developments in trade with Asia? Or have at least some economies in the region evolved to the point where a countercyclical fiscal stance--which indeed represents a significant break from the region's past--was appropriate ex ante in light of the severity of the crisis? The question is an important one, because it speaks to the crucial issue of whether, after two decades of reform, the region's macroeconomic institutions and circumstances have placed it in a position to be able to actively pursue macroeconomic stability in response to external shocks, rather than exercise restraint for the sake of preserving market confidence. In the event that the current recovery turns out not to be sustained or that an independent new crisis appears on the horizon in the near future, the formulation of an appropriate policy response requires that this question be addressed. Because theory suggests that the answer is likely to depend on country-specific conditions, we illustrate some of the important factors to be considered by focusing on the case of the seven largest economies in the region (the Latin American and Caribbean [LAC]-7 countries, consisting of Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela). …