1. Institutions of Macroeconomic Policy Jeffrey Frankel Harpel Professor Advanced Workshop on Global Political Economy Institute for Global Law & Policy, Harvard Law School Lecture II, May 31, 2012 Fiscal Policy Institutions

2. Lessons from small country institutions? Proper role of the government Some political economy models –The political budget cycle –Procyclical government spending –Emerging markets & the historic role reversal. Appendices – The U.S. fiscal situation –Some important macro relationships –“Fiscal conservatives” –The long-term US debt problem –US fiscal stimulus in 2013 –The bias in official forecasts

3. Where can countries look for policies and institutions to emulate ? In the past, some considered the great powers worthy of emulation: –UK in the 19 th century; –USSR after 1917; –Japan in the 1980s; –US in the 1990s. But each model was subsequently dis-credited.

4. 4 Advanced economies could learn some things from small & developing countries Countries that are small, or newly independent, or far-away, or emerging from a devastating war, are often more free to experiment with new policies and institutions, –than is the US or other large established countries. Not all the experiments will succeed. But some will. The results may include useful lessons.

5. A few examples of specific institutional innovations from the periphery worth emulating Singapore : i) paternalistic approach to saving ii) price mechanism to defeat urban traffic congestion Costa Rica & Mauritius : no standing army. Mexico: 1) non-partisan federal electoral institutions 2) Conditional Cash Transfers (OPORTUNIDADES) Mexico: hedging oil export revenues by means of options Chile: structural budget institutions Botswana: independently managed Sovereign Wealth Fund "What Small Countries Can Teach the World," Business Economics, April 2012.What Small Countries Can Teach the WorldBusiness EconomicsApril 2012 “Some Big Ideas from Small Countries,” European Financial Review, May 2011.Some Big Ideas from Small CountriesEuropean Financial Review

6. 6 Advanced economies could learn some things from developing countries Some Western institutions were successfully transplanted to other countries in the past, and versions now needed to be re-imported. An analogy. –In the latter part of the 19th century the vineyards of France were destroyed by Phylloxera vastatrix, a microscopic aphid. –Eventually a desperate last resort was tried: grafting susceptible European vines onto resistant American root stock. –It saved the European vineyards. –The New World had come to the rescue of the Old.

7. Proper role of the public sector: How big should the government be? Regulation vs. budget policy Market failures: –externalities and public goods, –monopoly and collusion, –imperfect information and missing markets, –income distribution. Government failures: –no access to decentralized information, –regulatory capture, –desire for re-election => pandering & short horizons, –rent-seeking, corruption, etc.

8. Proper role of the public sector, cont. Public finance functions: –sectoral allocation –income distribution –social insurance –macroeconomics. Macroeconomic time frames : –long-run growth –cyclical stabilization –short-run crisis stabilization.

9. Some political economy models Rent-seeking: lobbying, regulatory capture, corruption Mancur Olson’s logic of collective action: getting together to oppose a well-organized lobby of a few producers is not worth the cost, to many small consumers. “Starve the Beast”: tax  => BD  => G  (This is a political economy theory that fails.)

10. Some political economy models, continued The political budget cycle Pro-cyclical fiscal policy Institutions to constrain excessive government spending in boom times.

11. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Destabilizing fiscal policy In the textbook approach, benevolent governments are supposed use discretionary fiscal (& monetary) policy counter-cyclically: to dampen cyclical fluctuations expanding at times of excess supply, and contracting at times of excess demand. In practice, policy has often been destabilizing, particularly in developing countries.

12. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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?

13. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University were thought to pertain to 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. It appears that politicians on average fool voters roughly in the first 4 elections held. A.Drazen & A.Brender, 2005, JME, "Political Budget Cycles in New versus Established Democracies." Political budget cycles

14. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Can you get a political budget cycle even if voters & politicians are fully rational? Yes. Officials seek to convince voters that they are competent economic managers, by keeping taxes low before the election. They gamble on things turning out okay later. Kenneth Rogoff, AER, 1990, “Equilibrium Political Budget Cycles”

15. Copyright 2007 Jeffrey Frankel, unless otherwise noted Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted #2: Procyclical government spending –Due, e.g., to commodity cycle Dutch Disease in commodity booms, and the need to retrench in downturns. –Bias toward optimism in official forecasts especially in boom times, allowing procrastination in fiscal retrenchment. Political economy explanations for destabilizing fiscal policy

16. 16 Historically, fiscal policy has been procyclical in developing countries: Governments would raise spending in booms; and then be forced to cut back in downturns. So the correlation between spending &GDP was negative. Especially –among commodity-producers –in Latin America.

17. Correlations between Govt. Spending & GDP 1960-1999 procyclical G always used to be pro-cyclical for most developing countries. countercyclical Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours” Pro-cyclical spending Counter- cyclical spending }

18. 18 The historic role reversal Debt levels among rich countries (debt/GDP ratios ≈ 80%) are now twice those of emerging markets –and rising rapidly.. 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 2003-2007 –to run budget primary surpluses and cumulate reserves. –By 2007, Latin America had reduced its debt to 33% of GDP, as compared to 63 % in the United States. –And so were able to respond to global recession of 2008-09.

19. Ratio of public debt to GDP among advanced countries is the highest since the end of WW II Source: Carlo Cotarelli “Making Goldilocks Happy,” IMF, Apr. 20, 2012

20. Country creditworthiness is now inter-shuffled “Advanced” countries (Formerly) “Developing” countries AAA Germany, UKSingapore, Hong Kong AA+ US, France AA BelgiumChile AA-JapanChina A+Korea AMalaysia, South Africa A-Brazil, Thailand, Botswana BBB+Ireland, Italy, Spain BBB-IcelandColombia, India BB+Indonesia, Philippines BBPortugalCosta Rica, Jordan BBurkina Faso SDGreece S&P ratings, Feb.2012 updated 4/25/2012

21. In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy: Negative correlation of G & GDP. Frankel, Vegh & Vuletin (2012) procyclical countercyclical Correlations between Govt. Spending & GDP 2000-2009

22. Countries with good institutional quality tend to be the ones that have attained countercyclical fiscal policy Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Frankel, Vegh & Vuletin (2012)

23. 23 Wishful Thinking Some new econometric findings on a bias toward optimism in official budget forecasts among 33 countries. Official growth & budget forecasts tend toward wishful thinking : –unrealistic extrapolation of booms, especially 3 years into the future. The gap between the projected budget balance and the realized balance, on average: 0.2% of GDP at the 1-year horizon, 0.8 % at the 2-year horizon, and 1.5 % at the 3-year horizon. Optimistic forecasts allow procrastinated fiscal retrenchment. Frankel, “Over-Optimism in Forecasts by Official Budget Agencies and Its Implications.” in Oxford Review of Economic Policy.2011.

24. Optimism bias in official forecasts, continued Fiscal rules are the current fashion. Do they help? The forecast bias is worse among the EU countries supposedly subject to the budget rules of the SGP, –presumably because government forecasters feel pressure to announce they are on track to meet budget targets even if they are not. –When euro country deficits strayed above the 3% GDP limit, governments would adjust their forecasts, but not their policies. Example: The Greek government projected in 2000 that its budget deficit would shrink –below 2% of GDP one year in the future and –below 1% of GDP two years into the future, and –that it would swing to surplus 3 years into the future. The actual deficit: 4-5% of GDP, well above the 3%-of-GDP ceiling.

25. Even though true Greek budget deficits in most years were far in excess of the supposed limit (3% of GDP), 25 Source: Frankel & Schreger (2011) the official budget forecasts were always rosy. Until, in 2009, the bottom fell out of the budget.

26. 26 Econometric findings on a bias in official budget forecasts, continued Frankel, 2012, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” Central Bank of Chile 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. The result is that Chile was able to save the revenue during the copper boom that peaked in 2008 –and so had the space to spend in 2009, moderating the downturn.

27. What determines countries’ fiscal performance? Fundamentally: Quality of institutions. –This does not mean “tough” rules, if they lack enforceability like U.S. debt ceiling or Balanced Budget Amendment; or Stability & Growth Pact or revised Fiscal compact. –Better would be structural budget targets (Swiss) with forecasts from independent experts (Chile). The smartest commodity exporters save earnings in a Sovereign Wealth Fund (Norway, Botswana) –Some EM countries have graduated from pro-cyclical spending to countercyclical since 2000. –The US, UK & euro countries could learn from them.

28. Jeffrey Frankel James W. Harpel Professor of Capital Formation & Growth http://ksghome.harvard.edu/~jfrankel/ Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/ End of Lecture II Fiscal Policy Institutions

29. Appendices The U.S. fiscal situation –The standoff – How to reduce the deficit Some important macro relationships “Fiscal conservatives” The long-term US debt problem US fiscal stimulus in 2013 The bias in official forecasts Chile’s structural budget rule