metadata: authors: 0: author: Perry,Guillermo
count: Latin America,Caribbean
docna: 0: docna: Can fiscal rules help reduce macroeconomic
            volatility in the Latin America and Caribbean Region?
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Fiscal & Monetary Policy,Economic Adjustment and Lending,Primary Metals,Public Sector Economics,Public Finance Decentralization and
            Poverty Reduction,Inequality
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The debate on fiscal policy in Europe
            centers on how to let automatic stabilizers work while
            achieving fiscal consolidation. There is significant
            agreement on the importance of using fiscal policy as a
            counter-cyclical instrument, as monetary policy can no
            longer play this role. In contrast, most of the discussion
            on fiscal policy in Latin America and the Carribean region
            (LAC) deals just on solvency issues, largely ignoring the
            effects of the economic cycle. This is surprising as LAC
            economies are much more volatile than their European
            counterparts and have been generally applying pro-cyclical
            fiscal policies that exacerbate volatility. Some analysts
            and policymakers appear to think that counter-cyclical
            fiscal policies are a luxury that only industrial countries
            can indulge in or, at least, that LAC countries (with the
            exception of Chile) that have successfully put in place a
            counter-cyclical fiscal policy need to deal first with
            pressing adjustment and solvency issues before they attempt
            to reduce the highly pro-cyclical character of their fiscal
            policies. The author argues that this is a major mistake
            because the costs of pro-cyclical fiscal policies in LAC are
            huge in growth and welfare terms, especially for the poor,
            and because pro-cyclical policies and rules tend to develop
            a deficit bias, thus ending up being nonsustainable and
            noncredible. Perry illustrates both propositions. He then
            examines the causes of the pro-cyclicality of fiscal
            policies in LAC and discusses how well-designed fiscal rules
            may help to deal with the political economy and credibility
            factors behind pro-cyclicality. He also examines conflicts
            between flexibility and credibility in rules, showing how a
            good design can both facilitate the operation of automatic
            stabilizers while at the same time supporting solvency goals
            and enhancing credibility. Perry evaluates the experience
            with different fiscal rules and institutions in LAC to see
            the extent they have helped or can help to achieve the twin
            goals of avoiding deficit and pro-cyclical biases.
repnme: repnme: Can fiscal rules help reduce macroeconomic
            volatility in the Latin America and Caribbean Region?
display_title: Can fiscal rules help reduce
            macroeconomic volatility in the Latin America and Caribbean Region
listing_relative_url: /research/2003/06/2438506/can-fiscal-rules-help-reduce-macroeconomic-volatility-latin-america-caribbean-region
topicv3: Fiscal Stimulus and Fiscal Rules m1326652 1073,Poverty m1326687 695,Fiscal Policy m1327144 445,Copper m1503516 2934,Fiscal Rules m1584062 4486
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Off of Sr VP Dev Econ/Chief Econ (DECVP)
no_of_pages: 28
author_keys: 0: author_key: 123150
model_extractions: I POLICY **RESEARCH WORKING PAPER** 3080

# **Abstract**

The debate on fiscal policy in Europe centers on how to let automatic stabilizers work while achieving fiscal consolidation. There is significant agreement on the importance of using fiscal policy as a counter-cyclical instrument, as monetary policy can no longer play this role. In contrast, most of the discussion on fiscal policy in Latin America and the Carribean region (LAC) deals just on solvency issues, largely ignoring the effects of the economic cycle. This is surprising as LAC economies are much more volatile than their European counterparts and have been generally applying pro-cyclical fiscal policies that exacerbate volatility. Some analysts and policymakers appear to think that counter-cyclical fiscal policies are a luxury that only industrial countries can indulge in or, at least, that LAC countries (with the exception of Chile) that have successfully put in place a counter-cyclical fiscal policy need to deal first with pressing adjustment and solvency issues before they attempt to reduce the highly pro-cyclical character of their fiscal policies.

Perry argues that this is a major mistake because the costs of pro-cyclical fiscal policies in LAC are huge in growth and welfare terms, especially for the poor, and because pro-cyclical policies and rules tend to develop a deficit bias, thus ending up being nonsustainable and noncredible. Perry illustrates both propositions. He then examines the causes of the pro-cyclicality of fiscal policies in LAC and discusses how well-designed fiscal rules may help to deal with the political economy and credibility factors behind pro-cyclicality. He also examines conflicts between flexibility and credibility in rules, showing how a good design can both facilitate the operation of automatic stabilizers while at the same time supporting solvency goals and enhancing credibility. Perry evaluates the experience with different fiscal rules and institutions in LAC to see the extent they have helped or can help to achieve the twin goals of avoiding deficit and pro-cyclical biases.

This paper is a product of the Office of the Chief Economist, Latin America<sup>and the CaribbeanRegion.Copies of the paper</sup> are available free from the World Bank, 1818 H Street NW, Washington,<sup>DC 20433.Pleasecontact RuthIzquierdo, room</sup> I8-014, telephone 202-458-4161, fax 202-522-7528, email address<sup>rizquierdo@worldbank.org.Policy ResearchWorking</sup> Papers are also posted on the Web at http://econ.worldbank.org. The author<sup>may becontacted at gperry@worldbank.org.</sup> June 2003. (23 pages) _The Policy Research Working Paper Series disseminates the findings of work_<sup>_inprogress toencourage theexchange of ideas about_</sup> _development issues. An objective of the series is to get the findings_<sup>**_out_**</sup><sup>_quickly, evenif the presentations are less than fully polished. The_</sup> _papers carry the names of the authors and should be cited_<sup>_accordingly. The findings, interpretations, and conclusions expressed in this_</sup> _paper are entirely those of the authors. They do not necessarily represent_<sup>_theview of theWorld Bank, its Executive Directors, or the_</sup> _countries they represent._ Produced by Partnerships, Capacity Building, and Outreach
# CAN FISCAL RULES HELP REDUCE

# MACROECONOMIC VOLATILITY IN LAC?

Guillermo Perry, Chief Economist for Latin America and the Caribbean, World Bank' Prepared for the IMF/World Bank Conference on Fiscal Rules and Institutions Oaxaca, Mexico, February 2002

## 1. **INTRODUCTION**

The debate on fiscal policy in Europe<sup>2</sup> centers on how to facilitate the workings of automatic stabilizers while achieving fiscal consolidation. In particular, the discussion hinges on if the goal of "medium term" equilibrium established in the Stability and Growth Pact should be interpreted as a "cyclically adjusted structural balance," as Eichengreen and Wyplosz (1998) and a recent IMF paper<sup>3</sup> have argued, and on to what extent the Maastricht limit of 3% of GDP for eventual deficits<sup>4</sup> (waived only under "exceptional circumstances," such as a contraction of 2% of more of GDP) will be enough for countries affected by strong asymmetric shocks. In the recent past, fiscally responsible Scandinavian countries have run on occasion counter cyclical deficits as high as 8% of GDP. There is indeed significant agreement within the EU on the importance of using fiscal policy as a counter cyclical instrument, as monetary policy can no longer play this role.

I thank the useful comments of Nick Stern, Luis Serven, Augusto de la Torre, Rodrigo Suescuin, Mauricio Carrizosa, Sergio Schmukler and George Kopits to an earlier version of this draft.

**2** For several authors these rules, more than the currency union itself, have permitted to eliminate the "deficit bias" and improve the fiscal stance in some countries to such an extent that there was a significant reduction and convergence of interest rates before the start of the currency union. But, whatever the merits of these fiscal rules in reducing the deficit bias and facilitating the convergence of interest rates (as extensively discussed in the paper by Buti, M. and Giudice, G. (2002): "EMU's Fiscal Rules: What Can and Cannot be Exported," The European Commission, mimeo, February, at this Conference), there is still a debate about to what extent they will permit the operation of necessary counter cyclical fiscal policies. Many argue that the 3% deficit limit will prove to be too rigid, though the Commission can waive it under exceptional circumstances).

_3_ Eichengreen, B. and C. Wyplosz (1998):"Stability Pact. More than a Minor Nuisance," Economic Policy, April, and Hagemann, R. (1999):"The Structural Budget Balance. The IMF's Methodology," IMF working paper, July.

Mercosur and Andean countries have recently vowed to adopt fiscal and debt convergence ceilings, following the example of the EU, though with no enforcement instruments (as mentioned in Buti and Giudice, op. cit.). The Andean Community agreement also alludes to an escape clause during recessions.
In contrast, most of the discussion on fiscal policy in<sup>LAC deals just about</sup> long term sustainability issues, largely ignoring the effects of<sup>theeconomic</sup> cycle<sup>5</sup> . This is rather surprising as LAC economies are<sup>much morevolatilethan</sup> their European counterparts and have been generally applying procyclical<sup>fiscal</sup> policies that exacerbate volatility. Some analysts<sup>andpolicymakersappear to</sup> think that counter cyclical fiscal policies are a luxury that<sup>onlydeveloped</sup> countries can indulge in or, at least, that LAC countries<sup>(with theexception of</sup> Chile that has successfully put in place a counter cyclical fiscal policy)<sup>need to</sup> deal first with pressing adjustment and solvency<sup>issues beforethey attemptto</sup> reduce the highly procyclical character of their fiscal<sup>policies.</sup> In this paper I argue that this is a major mistake (in Section 2).<sup>First,</sup> because the costs of procyclical fiscal policies<sup>in LAC are hugein growth and</sup> welfare terms, specially for the poor. But, second,<sup>becauseprocyclical policies</sup> and rules tend to develop a deficit bias and thus end<sup>up being non sustainableand</sup> non credible. I then examine, in Section 3, the causes<sup>of the procyclicalityof</sup> fiscal policies in LAC. In Section 4 I discuss how<sup>welldesignedfiscal rules may</sup> help to deal with the political economy and credibility<sup>factors behind</sup> procyclicality of fiscal policies. Then, in Section 5, I examine<sup>conflictsbetween</sup> flexibility and credibility in rules, showing how<sup>a gooddesign may facilitatethe</sup> operation of automatic stabilizers, while at the<sup>same time supporting solvency</sup> goals and enhancing credibility. With these elements<sup>Isurvey in Section 6 the</sup> experience with different fiscal rules and institutions<sup>in LAC (Commodity</sup> Stabilization Funds, Fiscal Responsibility Laws,<sup>Stabilizing Transfers,the</sup> Chilean One percent Structural Surplus rule), analyzing<sup>to what extentthey have</sup> helped or can help to achieve the twin goals of avoiding<sup>deficitand procyclical</sup> biases. Finally, I conclude in Section 7 with a policy<sup>proposal, whichshould beof</sup> interest both for policymakers, market participants and<sup>International Financial</sup> Institutions.

# **2. WHY CARE ABOUT FISCAL PROCYCLICALITY?**

_A. Excess macroeconomic volatility in LAC reduces growth and_<sup>_is_</sup> _specially harmful for the poor._ Volatility has been since long a trademark of LAC's<sup>economic</sup> performance. By whatever measure, LAC economies<sup>havebeen more volatile</sup> than those of most other developed regions (see Figure<sup>16),and though LAC's</sup> volatility decreased during the nineties (Figure 2), after<sup>significantincreasesin the</sup> seventies and eighties, it remains twice as volatile<sup>as OECD countries,</sup>

> 5 With the major exception of IADB-based research:<sup>Gavin and Perotti (1996):"FiscalPolicyin Latin</sup> America: Volatility, Cyclicality and Modes of Adjustment,"<sup>OCE working paper,IADB; Gavin,M.,R.</sup> Hausmann, R. Perotti and E. Talvi (1996):"Managing<sup>Fiscal Policy in Latin Americaand the Caribbean:</sup> Volatility, Procyclicality, and Limited Creditworthiness,"<sup>OCE working paper,IADB.</sup>

> 6 Taken from "Securing Our Future in a Global Economy" by De Ferranti, D., G. Perry, I. Gill and L. Serven (2000), World Bank.

2
significantly more volatile than South Asia and slightly more volatile than East Asia in terms of volatility of real GDP growth. The picture is roughly the same when macroeconomic performance is measured by aggregate consumption or spending.

Economic instability can affect growth through different channels. Most of the existing empirical evidence shows that this impact is generally negative. Serven (1998) finds<sup>7</sup> that all of his five alternative definitions of economic instability -measured by the volatility of innovations to macroeconomic variables such as inflation, terms of trade, real exchange rate, growth rate and price of capital goods- are strongly negatively correlated with investment ratios. High volatility also tend to skew investment towards short run gains in a non-optimal way. Destruction of firms and banks informational and organizational capital during deep recessions have long lasting effects, as Stiglitz has pointed out. There 8 can also be irreversible human capital losses, as indicated in the last WB WDR . This findings were corroborated for LAC by an IADB report<sup>9</sup> , which found not only statistical evidence of a significantly negative effect of macro volatility on long term growth in the region, but also of a perverse relation between volatility and poverty, education, income distribution and financial deepening.

High volatility is indeed specially harmful for the poor. The poor have less human capital to adapt to downturns in labor markets. They have less assets and access to credit to facilitate consumption smoothing. There may be irreversible losses in nutrition and educational levels if there are no appropriate safety nets, as is usually the case in LAC (see below). It should not come as a surprise, then, that we find an asymmetric behavior of poverty levels during deep cycles: poverty levels increase sharply in deep recessions and do not come back to previous levels as output recovers (WB WDR<sup>1</sup> ).

_B. Procyclical fiscal policies may exacerbate macro volatility in LAC_ In our year 2000 Flagship publication at the Bank"<sup>1</sup> , we estimated the causes of excess volatility in LAC, taking volatility in OECD and East Asian countries as a benchmark. We found that nearly 1/3 was due to exogenous shocks (TOT are more volatile in LAC due to concentration in a few commodity exports; capital flows are also more volatile -though not as much as usually thought-); 1/3 to insufficient financial integration and development of domestic financial markets and 1/3 to volatility in macro policies (both fiscal and monetary). See figure 3. The importance of volatile monetary policies has been reduced overtime, but that is not the case with fiscal policies. Though the study does not identify the

> 7 Serven, L. (1998):"Macroeconomic Uncertainty and Private Investment in LDCs: An Empirical Investigation," World Bank working paper, September.

> 8 World Bank (2000):"Attacking Poverty," World Development Report 2000/2001.

> 9 "Hacia una Economfa Menos Volatil (Apendice tecnico)," Progreso Econ6mico y Social en America Latina, Informe 1995, Banco Interamericano de Desarrollo. 0World Bank (2000) op. cit.

> De Ferranti et al. (2000) op. cit.

3
kind of policies explaining this result, one possible candidate are fiscal policies conducted in a procyclical manner.

They indeed remain highly procyclical, as found by Gavin, Hausmann, Perotti and Talvi (1996)12, among others. These authors show that not only fiscal outcomes are procyclical but that fiscal responses have deepen the cycle particularly during recessions when they tend to generate upright surpluses (see Table 1), usually after major financing crisis leave no other choice. For example, their statistical results show that during recessions Latin American countries tend to generate a small surplus of 2.2 cents for every dollar of real output fall. In contrast, OECD countries tend to generate significant counter cyclical deficits<sup>of</sup> 61 cents.

**Table 1**

|**ResponseofFis**|**calBalancet **<br>**HighGrowth**|**oGDPGrowth**<br>**Perlods**|In**GoodTime**<br>**Low Growth**|**sandBad**<br>**Periods**|
|---|---|---|---|---|
||**OECD**|**Latin**<br>**America**|**OECD**|**LatIn**<br>**America**|
|Totalsurplus|**0.174**<br>|0.154<br>|0.611<br>|-0.022<br>|
|Primarysurplus|0.136|0.123|0.580|-0.049|

**Note:** Number give the typical impact of a one percentage point increase in real GDP on the ratio of the surplus to GDP. A positive number for the surplus implies that it moves in a stabilizing direction.

Source: Gavin, et al. (1996) _C. Procyclical fiscal policies add policy risk to the income risk of the poor_ Procyclical fiscal policies not only accentuate the cycle but are specially harmful for the poor. Indeed, we have found at the Bank<sup>13</sup> that social expenditures are kept at best constant as a percentage of GDP during downtums, and the more targeted social expenditures tend to fall as a percentage of GDP, when they should expand as the number of poor increases. As a consequence, in a typical downturn social expenditures per poor are reduced by 2% for each 1% of reduction in output. By contrast, social expenditures usually grow as a percentage of GDP<sup>in</sup> upturns, when they are less needed. That is, the procyclicality of safety nets -as<sup>a</sup> consequence of the procyclicality of fiscal policies- adds substantial policy risk<sup>to</sup>

> 12 Gavin et al. (1996) op. cit.

> 13 De Ferranti et al. (2000) op. cit.

4
the income risk for the poor. They thus suffer<sup>both from higherconsumption</sup> losses and from higher cuts in social transfers<sup>during deeprecessions.</sup>

# _D. Procyclical biases usually led to deficit biases_<sup>_in fiscal policies_</sup>

Procyclical fiscal policies have been often found<sup>to producea deficit bias.</sup> Indeed, whenever countries do not generate<sup>surplusesin booms,as theyshould,</sup> they will be forced by markets to compensate the workings<sup>of automatic</sup> stabilizers and reduce deficits by cutting<sup>expendituresduring downturns (see</sup> below). However, there are political and legal limits to<sup>whattheycan doin such</sup> cases. Thus the procyclical character of fiscal<sup>policies endsup generating</sup> unsustainable fiscal results over the cycle<sup>-asproved to be the case inseveral</sup> countries in Europe (for example, Italy and<sup>Spain) beforethe EU fiscal</sup> consolidation arrangements- and/or major macroeconomic<sup>crisis.This has been</sup> the experience in many Latin American<sup>countries,mostrecentlyin Argentina,</sup> Ecuador and Colombia in the nineties, where<sup>expansionaryfiscal policies during</sup> booms have been followed by a deep fiscal and<sup>macroeconomiccrisis in</sup> downturns.

# **3. WHAT ARE THE CAUSES OF THE**<sup>**PROCYCLICAL"BIAS" OF FISCAL**</sup> **POLICIES IN LAC?**

As mentioned before, it has been found<sup>that fiscal policies havebeen</sup> historically strongly procyclical in the region,<sup>in sharp contrast with whathas</sup> happened in many (though not all) OECD<sup>countries(see Table 2). Duringthe</sup> present downturn, only Chile -and Venezuela<sup>due to high oil prices- have been</sup> able to apply mild counter cyclical fiscal policies.<sup>Allothers havehadtoadopta</sup> strong procyclical stance. The case of Argentina<sup>was the moredramatic example.</sup> The reason for this behavior is a mutually<sup>reinforcing vicious circle</sup> conformed by the volatility of macroeconomic<sup>outcomes,the procyclicalityof the</sup> fiscal response and the limited access to international<sup>financialmarkets.</sup> Procyclicality in fiscal policies can indeed<sup>beexplained by the combinationof</sup> faulty policies and weak budgetary institutions<sup>in LAC withasymmetric</sup> information problems in international financial<sup>markets.</sup> First, there is a serious credibility problem for most<sup>LAC countriesthat</sup> attempt expansionary fiscal policies in a bust.<sup>It is not onlythat most of them</sup> arrive to the end of booms with fragile fiscal positions<sup>(highor moderatedeficits</sup> and relatively high debt stocks). There is in<sup>addition an obvious time</sup> inconsistency problem. Governments may borrow<sup>todayandchoosenot to pay</sup> back in good times; that is, they may continue<sup>to increaseindebtednessin good</sup> times. Indeed, most of them have not reduced indebtedness<sup>in past booms,so</sup> there is no reason for a financier to expect<sup>that they would do so next time.</sup> Almost no country in LAC but Chile have been<sup>able torun surplusesin booms,</sup> and very few have reduced indebtedness indicators<sup>in such episodes.Recent</sup> _5_
serious fiscal crises in both Colombia and Argentina can be traced to excessive expenditure increases during the booms -that is to the incapacity to achieve or maintain surpluses in good times. If that is the case, expansionary policies during bad times can be expected to lead to an intertemporally unsustainable outcome -a deficit bias- and can be rightly interpreted as leading to an increase in default risk.

**Table 2**

# **Cyclical Response of Fiscal Aggregates Latin American and the OECD**

||**ImpactofG **|**DPGrowth**|
|---|---|---|
||**OECD**|**Latin**<br>**America**|
|Totalsurplus(%ofGDP)<br>|0.25|0.08|
|Primarysurplus(%ofGDP)|0.22|0.05|
|TotalRevenue(%change)|0.84<br>|1.32|
|TotalExpenditure(%change)|**0.09**|0.61|

**Note:** Numbers give the typical impact of a one percentage point increase in real GDP on the budget category. A positive number for the surplus means that it moves in a stabilizing direction.

**Source:** Gavin, et al. (1996)

In these conditions the proper response of responsible creditors is not to finance an increased deficit during busts, or to do it at significantly higher spreads. In summary, the core of the problem would thus appear to be the incapacity to maintain surpluses in good times. As Gavin et al. put it: **"It is during booms that the seeds of crisis often are sown, although the crisis becomes evident only when the boom subsides."** But why is fiscal policy procyclical in booms? The main reasons lie in the political economy of fiscal policy and the lack of strong budgetary institutions. It is hard enough for a responsible Minister of Finance to avoid a deficit -specially in periods in which financing is readily available, as is usually the case in booms. It is much harder to maintain a too visible surplus through discretionary budgetary decisions. As Allen Schick's paper<sup>14</sup> in this Conference shows, there are strong pressures in any normal discretionary budget process to increase expenditures. Political incentives are aligned with spending out any potential surplus in a boom.

Such political pressures may also inhibit a responsible Minister of Finance to indulge in an explicit discretionary counter cyclical policy (or just to permit automatic stabilizers to operate) during downturns, as once the Pandora box (of a

> 14 Schick, A. (2002):"Budget rules vs. Political Will," Brookins Institution, mimeo.

6
deliberate increase in expenditures or an increase in the deficit) is opened it may not be easy to close: the political pressures may take you too far. And besides, as already explained, markets will punish any such move as they can not distinguish easily between a responsible counter cyclical policy and outright fiscal laxity.

Financial markets failures do indeed also contribute to fiscal procyclicality. Markets often finance outright deficits in booms that exacerbate the trend towards deficit biases. Spreads are found to be procyclical. Such behavior may be explained by underlying problems of asymmetric information, but this is not our focus here.

# **4. WHY** FISCAL **RULES MAY HELP**

For all these reasons authorities may well want to tie their hands and resort to automatic rules that may allow at least the automatic stabilizers to work during the cycle, and eventually to go farther into a regulated, rules-based counter cyclical fiscal policy.

Such rules would help to keep any surplus in good times out of sight and specially out of reach from the political process in normal discretionary budgetary decisions. But, why would they work? Why would policymakers stand by the rule when it bites and forces though decisions that they are not able to take on their own "free will"? Wouldn't they resort to ignore and change the rule or at least be tempted to "cheat" by "creative accounting"? More precisely and to our point, are rules capable to change the incentives to spend out potential surpluses in good times?

They may do that if they impose high enough exit costs, that compensate the perverse incentives to spend coming out of the normal budgetary political process. How can they impose high exit costs? Executive authorities will have strong incentives to comply with the rule if there are enforceable penalties (as with the Brazilian Fiscal Crimes Law) and if the rule is clear and simple enough that it does not leave much room for cheating. More important, "breaking" an explicit rule may indeed be more costly than just indulging in silent discretionary expansionary policies when there are no rules, due to the visibility of such a decision. This is particularly true if breaking the rule requires changing the Law and specially if it is a Constitutional law that requires a qualified majority. Opposition parties and the press will find in such cases a golden political opportunity to criticize the lack of responsibility of the governing political coalitions. For a responsible Finance Minister such a rule is just a gift of heaven, as it will facilitate to resist the pressures for excessive spending in booms from peers and politicians and to shift to them the political cost of an explicit break of the rule. The experience in Chile at the beginning of the democratic period during a major boom in copper prices, show clearly the usefulness of a tight legal rule for responsible economic authorities.

7
So much for booms. In downtums, a well designed rule may facilitate the operation of automatic stabilizers and enhance credibility to a well limited counter cyclical fiscal policy. This will be the case specially when the rule indeed permitted to obtain a surplus in the previous boom. If such surpluses were saved in a Stabilization Fund for bad times, the Government will have resources at<sup>its</sup> disposal to fully or partially finance the deficit in bad times, reducing the need to resort to market finance in a difficult period. The fact that the deficit in<sup>the</sup> downturn is predictable and limited by the rule -and that the same rule<sup>will</sup> credibly limit spending in future booms- will give a clear signal that<sup>the</sup> Government is not indulging in unsustainable lax policies, but just following<sup>an</sup> established sustainable rule, and may help convince markets to cover<sup>any</sup> remaining financing requirement. In other words, financers will face clear signals that distinguish a responsible and sustainable (limited and predictable) counter cyclical rules based fiscal policy from outright indulgence in intertemporally unsustainable policies. A good rule may thus help reduce problems associated with asymmetric infornation and facilitate financing of deficits in bad times.

In addition, such a rule will also be very helpful for a responsible Minister of Finance to avoid expenditure pressures to run wild and thus to go too far<sup>in the</sup> expansionary policy in downturns.

# **_5._ CONFLICTS BETWEEN FLEXIBILITY AND CREDIBILITY: TOWARDS FISCAL RULES THAT HELP REDUCE BOTH THE PROCYCLICAL AND THE DEFICIT BIAS.**

Any rule may entail a dilemma between flexibility and credibility.<sup>Too</sup> rigid a rule in the pursuit of credibility may lead to high costs in forgone flexibility. Even more, an excessively rigid rule may become altogether<sup>non</sup> viable. If this is the case economic actors may anticipate the non sustainability<sup>of</sup> the rule and it will not lead to more credibility. In other words, an excessively rigid rule may limit flexibility and not enhance credibility; it may entail only costs and few benefits if at all. It would just be a bad rule.

I would propose that this is the case with most rigid fiscal rules<sup>that</sup> attempt to reduce the deficit bias and thus to enhance solvency without correcting for the potential effects of shocks and the economic cycle, as has happened with some of the Fiscal Responsibility and Stabilizing Transfers Laws recently enacted in LAC -see below-. In such cases, if there is a positive shock (an increase in<sup>the</sup> price of oil for an oil exporting country) and/or a boom in economic activity, the rule will not be binding: it will be too easy to comply with, it will not help to improve the true underlying fiscal position and will permit a procyclical fiscal stance to accentuate the boom. On the other hand, if there is a negative shock and/or a downtum in economic activity the rule will become excessively tight and would exacerbate the downturn; it may thus tum out to be too difficult to comply with and abandoned altogether (as happened in both Argentina and Peru with the recently enacted FRL's). In other words, such rigid rules may not help avoid<sup>a</sup> 8
deficit bias precisely because they accentuate the procyclicality of fiscal policies. They are just not good and useful rules.

On the other hand, a rule that attempts to support counter cyclical fiscal policies but is not designed to achieve long term debt sustainability will<sup>also be</sup> unsustainable and non credible. It would not serve in the end any purpose.

A well designed rule must, as a consequence, attempt both to facilitate the operation of automatic stabilizers (or even permit a limited active counter cyclical fiscal policy) and avoid a deficit bias. This will by necessity make the rule somewhat more complex, but realistic and eventually useful.

In what follows I will review some LAC attempts with fiscal rules that have tried either to cope with pro ciclicality or with the deficit bias or both,<sup>and</sup> attempt to draw some practical conclusions.

# 6. **THE** EXPERIENCE **WITH FISCAL RULES IN LAC**

# _A. The Experience with COMMODITY STABILIZATION FUNDS_

The Annex to this paper presents an analysis of the Chilean Copper Stabilization Fund, the Colombian Coffee and Oil Stabilization Funds and the proposed Oil Savings and Stabilization Funds in Ecuador. From this review we can draw some general conclusions.

Stabilization Funds are easier to institute "before" the fact (when prices are low or before expected increases in quantities take place) and, in the case of shared revenues, when they treat all beneficiaries (central/federal governments and subnationals) in a symmetric way. This is highlighted by the experience of the Colombian Oil Stabilization Fund and was a major political consideration in the design of the Ecuadorian Oil Savings and Stabilization Funds.

They may indeed play a useful role to insure some savings from fiscal revenues associated with commodity export booms, specially where there are automatic saving rules and the accumulated net surplus remains "out of sight and out of reach" of the normal discretionary budget process. This is clear in both the cases of the Chilean Copper Stabilization Fund and the Colombian Coffee<sup>Fund</sup> and Oil Stabilization Fund.

However, in so far as they operate over a limited portion of current revenues, they cannot by themselves assure aggregate expenditure restraint during booms in economic activity (as happened in Colombia during the 90s or recently in Venezuela with the Fund for Macroeconomic Stabilization -FAEP-). In such cases one may end with some savings in the Funds but at the same time with an unsustainable deterioration of the "non-oil" budget. To avoid such a problem one would need a complementary rule to require that "non-oil" deficits be limited to 9
the interest yield of the Oil Fund (as in Norway) or that otherwise restrict overall expenditures.

Even when effective in helping to keep overall expenditure restraint in the booms (as in the case of Chile), if Commodity Stabilization Funds do not include an automatic rule for divestitures, they may play a too limited role in helping to execute counter cyclical policies in downturns (as happened in 1999), as there is no way for markets to distinguish between a responsible counter cyclical policy and just the beginning of fiscal laxness.

All these facts conform with our previous conceptual discussion, and have led these and other countries in the region to adopt or to plan to adopt additional rules with broader scopes and more automatic overall expenditure rules.

As a technical footnote, some of these attempts have eventually dealt with the difficult issue of distinguishing between temporary and permanent shocks in commodity prices by adopting as a reference price a moving average of past prices that help both smoothing out the effect of cycles and adapting gradually the level of expenditures to permanent shocks (which are welfare enhancing due to the inefficiencies associated with sharp increases or cuts in expenditures). For the same reason, some (as the Colombian and Ecuadorian Oil Stabilization Funds) have attempted to smooth out (or gradually adapt to a new level of) total revenues from oil exports, using a moving average of past dollar revenues as a benchmark. In both cases there was an explicit objective to adapt expenditures gradually to a sharp expected increase in the volume of exports.

But these moving average rules might be problematic when, as shown in the empirical evidence (see Cashin, Liang and McDermott (2000) and Cuddington"<sup>5</sup> ), commodity prices do not tend to revert towards a constant mean, but rather tend to experience random shocks of long durations. This means that when the shocks bring the prices down, an expenditure rule based on a moving average might lead to the exhaustion of the accumulated resources in the fund. If the shocks to the prices are positive and long-lasting, the fund might tend to accumulated large savings and thus produce costs in terms of forgone investment. Nevertheless, even a moving average rule might be better than no rule, given that political pressures tend to lead to the deficit bias and the quality of public investments tend to deteriorate remarkably during times of increases in the prices of commodities (or other types of booms). Moreover, these risks can be ameliorated by establishing rules that set ceilings and floors on the total savings of the fund. More generally, fiscal rules should aim to smooth overall government expenditures and eliminate the deficit bias, rather than just stabilize the portion

> _15_ Cashin, P., H. Liang and J. McDermott (2000): "How Persistent are Shocks to World Commodity Prices?," IMF Staff papers, vol. 47, #2. Cuddington, J. (1992): "Long-run Trends in 26 Commodity Prices: A Disaggregated Look at the Prebisch-Singe; Hypothesis," Journal of Development Economics, vol. 39, #2.

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related to commodity exports. There are other ways to accomplish this, as I discuss below.

_B. The Experience with FISCAL RESPONSIBILTYAND STABILIZING TRANSFERS laws._ Recently adopted Fiscal Responsibility Laws in Brazil, Argentina and Peru and projected ones in Colombia, Ecuador and other countries, have had as their main objective to help avoid deficit bias and thus achieve and maintain fiscal solvency. I will not discuss here in detail their potential virtues with respect to these objectives, but just to note that in contrast to the evident failure in the Argentinean and Peruvian case, the Brazilian law seems to offer more potential as it was a product of a broad political consensus and has been accompanied by a Law of fiscal crimes that could effectively punish deviations from the Law.

I will refer here more to the potential effects of these laws on the procyclical stance of fiscal policy. To the extent that they just set rigid specific targets for deficits or debt levels, they may turn out to reinforce the procyclical character of fiscal policy or become non viable. If the country in question faces an unexpected negative shock to its public finances -a fall in a major revenue source or a sharp downturn in activity- adherence to the rule may force authorities to cut public spending impeding the operation of "automatic stabilizers" and deepening the downturn. Or else, authorities may end up not being able to comply and the rule will be superseded, as happened in Argentina and Peru. A rule that does not take into account such possibilities may end up trading long term solvency benefits for short term costs, but it also may become non sustainable in the long term and thus non credible.

Some of these rules and similar legislation (specially in Argentina and Colombia) have, however, included provisions intended to achieve some stabilization of expenditures by States or Provinces during the cycle, as analyzed by the papers by Gonzalez, Rosenblatt and Webb and by Braun and Tommasi'<sup>6</sup> in this Conference. Unfortunately more often than not they have just offered a guarantee of minimum transfers that end up creating a serious fiscal contingency for the Federal (central) Government. This led to the incapacity to observe the commitment in the case of Argentina in 2001 and may well lead to a problematic outcome during the excessively long transition period established in the recent Constitutional reform in Colombia. These laws have however also contained some more promising norms that would limit transfers (or expenditures) to a moving average of past transfers or expenditures) after the "transition" periods.

16 Gonzalez, Rosenblatt and Webb (2002): "Stabilizing Intergovernmental Transfers in Latin America: A Complement to NationaltSubnational Fiscal Rules," mimeo and Braun., M. and M. Tommasi (2002): "Fiscal Rules for Subnational Governments. Some Organizing Principles and Some Latin American Experiences," mimeo.
Such a provision, applied both to National and subnational expenditures, could go a long way to help avoid the procyclicality of fiscal policies and facilitate at least the operation of built-in stabilizers, while at the same time helping to obtain solvency goals by avoiding a deficit bias. Even better, the goals established in such laws might be coined in terms of "structural" balances, taking explicit account of cycle and primary commodity price effects, as discussed below.

# _C. THE CHILEAN STRUCTURAL BALANCE RULE_

Chile recently adopted a more ambitious rule designed to facilitate credible counter cyclical policies and enhance fiscal solvency. It is elegant and simple: an explicit commitment to keep a 1% structural surplus each year. The structural balance is estimated by removing the effects of variations in copper prices (by using a panel of experts to estimate the long term price trend) and the economic cycle on revenues (by using revenue elasticity estimates and a measure of potential GDP).

This rule will force the government to high surpluses during booms and high copper prices and will allow to run moderate deficits during downtums and low copper prices. For example, the estimated budget deficits for 2001 and 2002 are consistent with the structural surplus required by the rule.

The fact that both the size of the surplus in good times or the deficit in bad times are constrained and predictable, will facilitate to curb political pressures to either use the surpluses or enlarge the deficits (as it would imply the breaching of the 1% surplus rule). It will also enhance the credibility of fiscal policy vis a vis the markets -provided, of course, that results are close enough to the rule-, as the deficits in bad times can be clearly anticipated and will not signal a relaxation of the fiscal stance.

The use of this rule is helping Chile to conduct a credible counter cyclical fiscal policy at present. As Anne Krueger praised recently in Santiago, Chile is using "virtue with a purpose" as, in her words, fiscal conservatism is not a purpose on itself but a means to keep good access to markets, low interest rates and the capacity to conduct expansionary policies in bad times.

Credibility gains from this new rule have largely been immediate, given the track record of Chile and the fact that authorities are using credible measures and projections of potential output (which have been used for long for the conduct of monetary policy) and revenue elasticities<sup>1 7</sup> . Other countries willing to follow 17 Technical problems are however non negligible. Simulations exercises indicate that (by just using present output gap models and revenue elasticity estimates) the potential for counter cyclical smoothing of the present rule would be fairly limited, as effects of the estimated cyclical adjustment would be just a small fraction of expected corrections related to the volatility in copper prices. In other words, as presently applied the rule would not do much more than what was accomplished by the Copper Stabilization Fund.

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this example would probably have to establish first a sound analytical/statistical basis (to be able to credibly predict or assess potential output, and to include a correction on interest payments -which may be the most procyclical component of the fiscal balance, a problem that Chile does not face- or define the structural balance in _primary_ terms -altogether excluding interest payments<sup>18</sup> ).

They should also probably adopt such a rule in good times, so as to build some track record before the bad times come, and establish it with force of law and adequate enforcing (penalty for noncompliance) measures. Chile may also find useful to "institutionalize" more the rule, as at present it is just the expression of the policy of the present government (see figures 4 and 5).

# 7. CONCLUSIONS **AND A POLICY PROPOSAL. TOWARDS SUSTAINABLE COUNTER CYCLICAL FISCAL POLICIES**

The above discussion highlights several facts. First, that it is as important to try to reduce procyclical bias as it is to eliminate the deficit bias in Latin American fiscal policies. The procyclical bias accentuates macroeconomic volatility, with harmful effects on growth, and hurt specially the poor, by forcing sharp reductions in social expenditures per poor person precisely at the time when they are most needed, thus adding unnecessary "policy risk" to the income risk of the poor.

Second, that fiscal policies or rules must attempt to deal with both problems at the same time. Obviously, counter cyclical policies that contribute to a deficit bias will not be sustainable. But also, policies or rules that attempt to reduce the deficit bias and achieve fiscal solvency while increasing procyclicality, are likely to prove non sustainable over the medium run.

Properly designed fiscal rules may indeed help to cope with the political economy and credibility problems that are behind the operation of procyclical fiscal policies (and deficit biases). They may help to contain political pressures to spend away potential surpluses in good times by tying the hands of authorities and keeping "surpluses" out of reach of the political process associated with normal discretionary budgetary practices, **as long** as **they are successful in imposing high exit costs from the rule.** They can give credibility to the sustainability of deficits in downturns if in fact they have resulted in surpluses in upturns, and because such deficits will be entirely predictable and limited by the rule, thus increasing the likelihood that they will be financeable (they would be partly or wholly financed by the savings achieved in good times). The fact that deficits will be limited by the rule, may also help to keep pressures for excessive deficits at bay during bad times.

> 18 Hausmann's paper in this Conference: "Unrewarded Good Fiscal Behavior: The role of Debt Structure," show that interest payments have been the more volatile component of public expenditures in LAC.

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Of the different rules examined, the most convenient seems to be a goal of structural balance, or modest structural surplus, such as the one recently adopted by Chile. Such a rule would permit full operation of automatic stabilizers during the economic cycle and avoid sharp changes in public expenditures associated with changes in fiscal revenues from commodity exports receipts.

> Other countries in the region would benefit from adopting a similar

> structural balance framework for the presentation and discussion of their fiscal policy, even if they do not adopt a structural balance rule. To do so, in addition to continue improving their fiscal accounting, they will need to have reliable estimates of potential output and revenue elasticities. They would also have to develop ways to adjust for the cyclical components in interest rates or, alternatively, to base their policy goals on adjusted primary balances. IMF assistance could be of great help as it has developed a well tested methodology that it regularly applies to analyze and discuss the fiscal stance of OECD countries. The IMF might also consider requiring a structural balance framework as part of the Code of Good Practices on Fiscal Transparency.

Structural balance rules should form the basis of future attempts to establish Fiscal Responsibility Laws and Stabilizing Transfers for subnationals. Most recent designs of FRL, while already adopted or at a discussion state, rely excessively on rigid quantitative ceilings that do not take into account the effects of shocks or the economic cycle. They are thus likely to accentuate procyclicality of fiscal policies and to prove non sustainable in the end, as happened in Argentina and Peru. Such a limitation may reduce ex-ante their credibility, severely reducing their usefulness. The same can be said of recent attempts to adopt rules for stabilizing transfers to subnationals in Argentina and Colombia: by instituting a long transition period of rigid quantitative targets, they can become minimum guarantees that add to Federal or Central Government fiscal risks.

Those countries that are not yet in the capacity of adopting credible structural balance frameworks and rules, may benefit from considering more simple rules that would limit (real) expenditure growth to a moving average of past (real) revenue increases. Such a simple rule (that was included for the "steady state" in the Colombian OSF, in the Argentine FRL and the Colombian and Argentine stabilizing transfers provisions, though in some cases with excessively short periods for estimating averages) would significantly reduce procyclicality of fiscal policies and avoid a deficit bias.

Structural goals would be set according to fiscal consolidation needs. Thus, a country that starts below a sustainable structural balance should set goals that permit a gradual approximation to the required level. Alternatively, it would limit the expansion of expenditures to an increasing percentage (with a ceiling of 100%) of a moving average of real revenue increases. Thus, there is no need to wait until fiscal consolidation is obtained to introduce rules that make compatible the achievement of such goals with removing the procyclicality of fiscal policies.

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Most importantly, it would be extremely useful if the IMF (and MDB and analysts in the private sector) decide to use systematically a structufal balance framework when examining and discussing the fiscal stance of all countries (as the IMF already do for OECD countries) and set the goals of programs accordingly. After all, there is no good reason not to extend best practice already applied to the first world to the analysis and design of policies in the third world. It was most unfortunate that not only local authorities and analysts, but the IFIs and international markets indulged in accepting and praising highly expansionary procyclical fiscal policies in many Latin American countries (most notably in Argentina) during the good times in the early nineties, which turned out to plant the seeds of major fiscal crisis or at least significant fiscal stress during the bad times after 1998. We should not repeat these mistakes in the future.

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