budgetary constraint of the whole country; (5) moral hazard spending behavior of subnational government reflecting implicit or explicit bailout insurance by the central government; (6) free rider behavior of subnational governments taking advantage of market access conditions of the country as a whole, but failing to adhere to the fiscal rules established by the central or federal government; and (7) time inconsistency problems of policies agreed _ex-ante_ but not adhered _ex-post_ .<sup>4</sup> The literature is near-unanimous in its description of the fundamental difference between developing countries and industrial countries in terms of fiscal policy. While fiscal policies in industrial countries have typically been a-cyclical or countercyclical, fiscal policies in developing countries—including most of Latin America—have been pro-cyclical (see for example Gavin and Perotti [1997] and Talvi and Vegh [2005]). In a study analyzing data on government consumption for 49 developing countries during the period from 1960-2006, Ilzetzki and Vegh (2008) found evidence that not only has fiscal policy in developing countries been pro-cyclical, but expansionary as well, with fiscal policy exacerbating the effects of the business cycle.<sup>5</sup> Their results regarding procyclical fiscal policy in high income countries are inconclusive, but they do confirm that fiscal policy has been expansionary as well.

The international evidence also has shown interference with the operation of automatic stabilizers: the cyclical sensitivity of fiscal balances has been lower than what would have been expected from the action of automatic stabilizers alone, implying an offsetting impact from discretionary fiscal policy actions (Balassone and Kumar 2007). The main cause of the deficit bias of fiscal policy, in both industrial and developing countries discretionary policy, has been the asymmetric response of fiscal policy with pro-cyclicality occurring in good times. During upturns the effect of automatic stabilizers has typically been offset by discretionary fiscal expansions while during downturns the fiscal balance deteriorates setting a deteriorating fiscal balance trend (see Manasse 2006). In some European countries during the period from 1970 to 2000 deficits increased in downturns but did not fall in periods of high growth as a result of countries offsetting the effects of automatic stabilizers via tax cuts or expenditure increases. The pro-cyclicality of fiscal policy in also a stylized fact in Latin American countries, but in this case the fiscal policy has also generally been pro-cyclical in bad times, reflecting borrowing constraints and the overall pro-cyclicality of capital flows (see Haussman 2004; and Kaminsky et al., 2004).

The literature also points to institutional arrangements as a factor in the procyclical bias of fiscal policy. Fiscal pro-cyclicality appears to be more pronounced in more corrupt democracies because of a political agency problem that leads voters to reduce the political rents. As voters observe the state of the economy but not the rents appropriated by corrupt governments during a boom they demand more government

> 4 The fundamental problem of time inconsistency in government policy is that a policy that is optimal at a certain point in time becomes suboptimal later on. As individuals realize that the government has an incentive to deviate from its previously announced policy they behave accordingly. The solution to time inconsistency is a credible commitment by the government to adhere to its policy actions despite changing circumstances.

> 5 The study by Ilzetzki and Vegh (2008) included eight Latin American countries: Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, and Venezuela.

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