# **1. INTRODUCTION**

A climate of mistrust towards discretionary fiscal policy is growing in Latin America. De Ferranti, Perry, Gill and Servén (2000) found that a significant fraction of Latin America’s excess volatility vis-à-vis industrial economies is due to fiscal policy volatility. The underlying reason is that fiscal policy tends to be procyclical in the region and, instead of smoothing economic fluctuations as in textbook macroeconomics, it contributes to exacerbating them. The destabilizing conduct of fiscal policy has been documented in various cross-country studies (Gavin et al., 1996; Gavin and Perotti, 1997). Furthermore, Fatás and Mihov (2004), using an enlarged sample of countries, including some in Latin America, demonstrated a discernable positive relationship between discretionary fiscal policy changes and macroeconomic volatility and a negative one between the latter and economic growth.

The distrust of fiscal activism is a widespread phenomenon in the developed world nowadays as is the concomitant focus, in public policy and academic circles, on an alternative type of fiscal policy - a non-discretionary one - based on the built-in flexibility of taxation and automatic stabilization. _Let the fiscal automatic stabilizers work_ seems to be the new mantra being chanted in the felt need for protection from discretionary fiscal management. Auerbach and Feenberg (2000) and Auerbach (2002) recommend heavier reliance on automatic stabilizers for macroeconomic stabilization purposes for the U.S. given the difficulties in conducting countercyclical fiscal policy. The authors claim that there is little evidence that discretionary fiscal policy has been effective in smoothing shocks and contend that active policy changes suffer from information, political and economic lags. Romer and Romer (1994) reached a similar conclusion in a study of the contribution of monetary and fiscal policies to the ending of eight U.S. postwar recessions. Their study documented the fact that discretionary fiscal impulses have been too small to have had a significant role in ending downturns while automatic fiscal policy seemingly exhibited the magnitude, timing and consistency to have had a stabilizing influence in all recoveries. Taylor (2000) espoused monetary policy to do the countercyclical task, ‘taking as given the workings of the automatic stabilizers.’ The comparative advantage of monetary policy is attributed to shorter implementation lags, greater flexibility to adjust the policy stance and lower political constraints. Following the same line of reasoning, the institutional arrangement of the EMU has been set up to hold a strong stance against the use of discretionary fiscal policy to fine-tune the economy. The fiscal apparatus of the Maastricht Treaty and the Stability and Growth Pact require a medium-term fiscal position of ‘close to balance or in surplus’ and relies on the operation of automatic stabilizers as the main tool for dealing with country-specific shocks.

The emerging public policy consensus appears to have some additional backing in the empirical work of Fatás and Mihov (2003), who show that fiscal policy discretion has harmed macroeconomic stability and caused the deterioration of long-term growth in a sample of OECD countries while Fatás and Mihov (2001) found a strong negative correlation between automatic stabilizers, proxied by government size, and output volatility for the same sample of OECD countries given above and for the states in the U.S.

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