1. L26: Failures of Fiscal Policy : Creditworthiness & Cyclicality
Debt problems
Debt dynamics: Unstable equilibrium
Sovereign spreads & country risk ratings
Procyclical fiscal policy
Industrialized vs. developing countries
Historic role reversal ( ) ?
The political budget cycle
The commodity cycle
Optimism bias in official budget forecasts
Institutional fix: The case of Chile

2. Debt dynamics line shows the relationship between b and (i-n), for db/dt = 0. It slopes down.
= d (i - n) b where ,
n  nominal growth rate, and d  primary deficit / Y .
db/dt=0
range of explosive debt
range of declining Debt/GDP ratio b
Copyright 2007 Jeffrey Frankel, unless otherwise noted 2

3. Debt dynamics, continued
It is best to keep b low to begin with, especially for “debt-intolerant countries.”
Otherwise, it may be hard to keep db/dt < 0, if
i rises some time,
due to either a rise in world i*, or
an increase in risk concerns;
or n exogenously slows down.
Now add the upward-sloping supply of funds curve.
i includes a default premium, which probably depends in turn on db/dt.
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted 3

4. Debt dynamics, with inelastic supply of funds
db/dt = d (i - n) b.
db/dt=0
Greece 2011
range of explosive debt
range of declining Debt/GDP b

5. Debt dynamics graph, with possible unstable equilibrium
Supply of funds line i
Initial debt dynamics line {
sovereign
spread
iUS

6. (1) Good times. Growth is strong. db/dt ≈ 0. Default premium is small.
(2) Adverse shift. Say growth n slows (or i rises). Debt dynamics line shifts down, so the country suddenly falls in the range db/dt>0. => gradually moving rightward along the supply-of-lending curve.
(3) Adjustment. The government responds by a fiscal contraction, turning budget into a surplus (d<0). This shifts the debt dynamics line back up. If the shift is big enough, then once again db/dt=0.
Ireland 2011
(4) Repeat. What if there is a further adverse shift? E.g., a further growth slowdown (n↓) in response to the higher i & budget surplus. => b starts to climb again. But by now we are into steep part of the supply-of-lending curve. There is now substantial fear of default => i rises sharply. The system could be unstable….
Greece 2011

7. Sovereign spreads depend on risk perceptions, as reflected in the VIX (option-implied volatility of US stock market)
Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, March 2011

8. Effect of rating on country interest spreads, controlling for VIX, debt/GDP, Res/GDP, growth, etc.
Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, March 2011
“Sovereign Credit Ratings and Spreads in Emerging Markets: Does Investment Grade Matter?”

9. Country risk ratings, S&P 2011
Advanced countries
Former developing countries
Developing countries
Country
Rating
 Canada
AAA
 Singapore
 Germany
 Hong Kong
 United States
AA+
 Belgium AA
 Taiwan
AA-
 China
 Japan
 Chile A+
 Botswana A-
 Spain
 Malaysia
 Italy A
 South Korea
 Thailand
BBB+
 S. Africa
 Brazil
BBB
 Portugal
BBB-
 Peru
 Iceland
 India
 Indonesia
BB+
 Greece CC
 Nigeria B+

10. The historic role reversal
Some emerging markets have earned credit ratings higher than some so-called advanced countries.
Over the last decade some emerging market countries finally developed countercyclical fiscal policies:
They took advantage of the boom years
to run budget primary surpluses.
By 2007, Latin America had reduced its debt to 33% of GDP,
as compared to 63 % in the United States.
Debt levels among top-20 rich countries (debt/GDP ratios ≈ 80%) are now twice those of the top-20 emerging markets.

11. Pro-cyclical fiscal policy THESE 3 PAGES WERE IN L3 APP. IN 2010
In the textbook approach, benevolent governments are supposed use discretionary fiscal (& monetary) policy to dampen cyclical fluctuations.
expanding at times of excess supply, and
contracting at times of excess demand.
In practice, policy has often been procyclical, i.e., destabilizing, in developing countries.
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

12. Governments would raise spending in booms;
Historic role reversal in the cyclicality of fiscal policy in industrialized vs. developing countries Previously, fiscal policy was procyclical in developing countries:
Governments would raise spending in booms;
and then be forced to cut back in downturns.
Kaminsky, Reinhart & Vegh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006), Ilzetski & Vegh (2008) and Medas & Zakharova (2009).
Especially Latin American commodity-producers.
Gavin & Perotti (1997), Calderón & Schmidt-Hebbel (2003), Perry (2003), and Villafuerte, Lopez-Murphy & Ossowski (2010).

13. Correlations between Gov.t Spending & GDP }
Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”
procyclical
Pro-cyclical spending
countercyclicall
Counter- cyclical spending
G always used to be pro-cyclical for most developing countries.

14. The procyclicality of fiscal policy, cont.
An important development -- some developing countries, including commodity producers, were able to break the historic pattern in the most recent decade:
taking advantage of the boom of
to run budget surpluses & build reserves,
thereby earning the ability to expand fiscally in the crisis.
keep 14 14

15. Correlations between Government spending & GDP 2000-2009
procyclical
Frankel, Vegh & Vuletin (2011)
In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy: Negative correlation of G & GDP.
countercyclical

16. Countries with good institutional quality tend to be the ones that have attained countercyclical fiscal policy
Frankel, Vegh & Vuletin (2011)
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

17. Political economy explanations for destabilizing fiscal policy
#1 : Political Budget Cycles
Politicians expand just before elections, so that rapid growth will buy votes; the cost comes later (debt, inflation, reserve loss, devaluation)
Example: The Mexican sexenio (until 2000)
Do politicians really fool voters this way?
#2: Procyclical government spending
Due, e.g., to commodity cycle
Dutch Disease in commodity booms,
and the need to retrench in downturns.
New: Optimism bias in official forecasts
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Copyright 2007 Jeffrey Frankel, unless otherwise noted

18. A.Drazen & A.Brender, "Political Budget Cycles in New versus Established Democracies," JME, 2005.
Summary: Political budget cycles were once thought a phenomenon of less developed economies.
But they turn out to have been a phenomenon of “new democracies” per se [e.g., Central Europe],
where fiscal manipulation may be effective because of lack of experience with electoral politics or lack of the sort of information that voters in more established democracies use.
It appears that politicians can and do on average fool voters roughly in the first 4 elections held.
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Copyright 2007 Jeffrey Frankel, unless otherwise noted 18

19. Can you get a political budget cycle
even if voters & politicians are fully rationale? Yes.
Rogoff (1990): officials seek to signal to voters
that they are competent economic managers,
by keeping taxes low before the election.
Kenneth Rogoff, 1990, “Equilibrium Political Budget Cycles,” American Economic Review, 80(1), pp
Torsten Persson & Guido Tabellini, 2002, “Political Economics and Public Finance,” Handbook of Public Economics, Vol.3, pp
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

20. Some new econometric findings on a bias toward optimism in official budget forecasts among 33 countries Frankel, 2011, “Over-Optimism in Forecasts by Official Budget Agencies and Its Implications.” forthcoming in Oxford Review of Economic Policy. NBER Working Paper , 2011, “A Solution to Fiscal Procyclicality:  The Structural Budget Institutions Pioneered by Chile,” Central Bank of Chile. NBER WP  
Official growth & budget forecasts tend toward wishful thinking :
unrealistic extrapolation of booms, especially 3 years into the future.
The bias is worse among the European countries supposedly subject to the budget rules of the SGP,
presumably because government forecasters feel pressured to announce they are on track to meet budget targets even if they are not.
Chile is not subject to the same bias toward over-optimism in forecasts of the budget, growth, or the all-important copper price.
The key innovation that has allowed Chile to achieve countercyclical fiscal policy:
not just a structural budget rule in itself,
but rather the regime that entrusts to two panels of experts estimation of the long-run trends of copper prices & GDP.

21. Appendix 1 The procylicality of fiscal policy: More on optimism bias & the case of Chile

22. Ten econometric findings regarding bias toward optimism in official budget forecasts. Frankel, 2011, “Over-Optimism in Forecasts by Official Budget Agencies and Its Implications.” forthcoming in Oxford Review of Economic Policy. NBER Working Paper , 2012, “A Solution to Fiscal Procyclicality:  The Structural Budget Institutions Pioneered by Chile,” forthcoming, Series on Central Banking Analysis & Economic Policies (Central Bank of Chile), vol.17. NBER WP   
Official forecasts of budgets & GDP in a sample of 33 countries are overly optimistic on average.
The bias toward optimism is:
stronger the longer the forecast horizon.
greater in booms
Greater among governments that are under budget rules (SGP).
Chile’s official forecasts are not overly optimistic.
Chile has apparently avoided the problem of official forecasts that unrealistically extrapolate in boom times.

23. 10 econometric findings regarding bias toward optimism in official budget forecasts, continued.
The key macroeconomic input for budget forecasting in most countries: GDP In Chile: the copper price.
Real copper prices mean-revert in the long run,
but this is not always readily perceived.
A mere 30 years of data cannot reject a random walk.
Uncertainty (option-implied volatility) is higher when copper prices are toward the top of the cycle.

24. Official forecasts of budgets & GDP are overly optimistic on average in a sample of 33 countries
(1) Government forecasts of the budget balance (App. Table 1)
The average across all countries is an upward bias of :
0.2% of GDP at the 1-year horizon,
0.8% of GDP 2 years ahead,
and a hefty 1.5% at 3 years ahead.
(2) Government forecasts of the GDP growth rate (App.Table 2)
0.4 % when looking 1 year ahead,
1.1 % at the 2-year horizon,
and 1.8% at 3 years.

25. Official forecasts are overly optimistic, continued
The bias appears in the US & other advanced countries,
not particularly among commodity-producers in these data.
Chile on average under-forecast its growth rate,
by 0.8 % at the 1-year horizon.
The sample of 33 countries:
26 from Europe (of which, 16 € members)
1 other major advanced country (US), and
3 advanced commodity-exporters (Australia, Canada, & NZ),
3 middle-sized emerging market commodity-exporters (Chile, Mexico & South Africa).
Getting data on official forecasts
is very hard for others in this last category.
Easy for Europe.

26. Official budget forecasts are biased
more if GDP is currently high & especially at longer horizons
Budget balance forecast error as % of GDP, Full dataset
(1)
(2)
(3)
One year ahead
Two years ahead
Three years ahead
GDP relative to trend
0.093*** (0.019)
0.258*** (0.040)
0.289*** (0.063)
Constant
0.201
0.649***
1.364***
(0.197)
(0.231)
(0.348)
Observations
398
300
179
33 countries
Variable is lagged so that it lines up with the year in which the forecast was made. *** p< Robust standard errors in parentheses, clustered by country.

27. Budget balance forecast error as a % of GDP, Full Dataset
(6) Official budget forecasts are more optimistically biased in countries subject to a budget deficit rule (SGP)
Budget balance forecast error as a % of GDP, Full Dataset
(1)
(2)
(3)
(4)
One year ahead
Two years ahead
SGPdummy
0.658
0.905**
0.407
0.276
(0.398)
(0.406)
(0.355)
(0.438)
SGP dummy * (GDP - trend)
0.189** (0.0828)
0.497*** (0.107)
Constant
0.033
0.466*
(0.228)
(0.248)
(0.229)
(0.249)
Observations
399
300
398
33 countries
*** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country.

28. Poll ratings of Chile’s
President over time
In 2009, the popularity of the Socialist President of Chile Michelle Bachelet rose sharply (both with respect to handling of the economy and overall), to the highest levels since the restoration of democracy 20 years earlier. More remarkable: the rise in the polls, from very low to very high, came just as the economy moved from rapid growth to slow growth -- not the usual pattern. Why?
Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009

29. Poll ratings of Chile’s Presidents and Finance Ministers
In August 2009, the popularity of the Finance Minister, Andres Velasco, ranked behind only President Bachelet, higher than any other minister since democracy. Why?
And the
Finance
Minister?:
August 2009
Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009

30. Chile’s structural budget rule
Government must set a fiscal target:
In booms, can only spend structural revenue,
must save the cyclical component.
Structural ≡ economy at full employment & price of copper at its long-run level
Under Bachelet, structural deficit target was 0.
Estimates of structural vs. cyclical are made by commissions of experts, not politicians, which avoids wishful thinking.
In other countries, official fiscal forecasts have optimism bias.
JF, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,”
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted 30

31. In 2008, a copper price spike had looked permanent to many
In 2008, a copper price spike had looked permanent to many. In 2009, the price reverted toward its long run trend.

32. Copper prices spot, forward, & forecast 2001-2010
Forecasts internalize the tendency for copper prices to revert toward long-run equilibrium
Copper prices spot, forward, & forecast
spot price
official forecast

33. Application to other countries
Any country could adopt the Chilean mechanism,
not just commodity-exporters.
Suggestion: give the panels more institutional independence
as is familiar from central banking:
laws protecting them from being fired.

34. Appendix 2: Recap of debt dynamics
where Y ≡ nominal GDP
where n  nominal economic growth rate and d  primary deficit / Y .
= d + i b - bn = d (i - n) b.
=> Debt ratio explodes if d > 0 and i > n (≡ r > real growth rate) . 34