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F Latin American Development Forum Series This series was created in to promote debate, disseminate information and analysis, and convey the excitement and complexity of the most topical issues in economic and social development in Latin America and the Caribbean. Baeza and Truman G. Packard vii. Jack M. Guillermo E. Michael Smart is professor of economics at the University of Toronto and research fellow at the C. Howe Institute in Canada.

Economic Policy and Stabilization in Latin America

Figures 1. Tables 1. The primary objective of the program is to offer analysts and policy makers a solid analytical basis for the understanding and formulation of policies through a collaborative effort that brings together a diverse team of researchers from within and outside the Bank.

The editors wish to extend their thanks for the invaluable contributions of numerous individuals who participated in the program. Special thanks go to professors Olivier Blanchard and Francesco Giavazzi, both of whom kindly agreed to publish their work in this book. Introduction This volume covers the conduct of fiscal policy in Latin America, and its consequences for macroeconomic stability and long-term growth.

Importantly, the essays in the book show that these fiscal policy biases are exacerbated by the excessive focus of authorities, markets, and international financial institutions on short-term indicators of fiscal health—such as government debt and cash flows—that capture liquidity trends but can be misleading for tracking intertemporal solvency.

Moreover, flawed policies reflect perverse political economy incentives. Correcting these incentives requires not only political leadership but also institutional solutions, including well-designed fiscal rules—as the example of Chile in recent years illustrates. This volume offers policy and institutional recommendations to help overcome the procyclical and anti-investment biases of fiscal policy, and we hope it will be of interest to academics and practitioners.

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The book is organized as follows. This chapter offers an integrated overview of the themes covered in the rest of the volume. The chapter guides 1. The rest of the volume is organized in two parts.

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The rest of this introductory chapter consists of four sections. Section II examines recent trends in fiscal policy in the region and introduces the two main themes of the book. Sections III and IV present an overview of the topics covered in the two parts of the book, as well as the conclusions of the corresponding chapters.

Section V summarizes the implications for future fiscal analysis and policy management. Latin America has made significant progress with fiscal policy management since the infamous days of the debt crisis of the s that led to the so-called lost decade. Large variations are evident across countries as shown in panel B of figure 1.

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Perhaps not. To start with, the improvement in debt and fiscal balance ratios in the most recent years have a lot to do with allegedly temporary events: booming world economic activity, exceptionally high commodity prices, and low international interest rates and country risk spreads. A reversal in these conditions could bring back fiscal stability concerns to center stage in many countries.

After all, standard indicators of fiscal health were also reasonably good by —97, before the Russian and East Asian crises led to a major retrenchment of capital flows to the region. Ensuing increases in interest rate spreads, along with currency depreciation and recession, revealed the underlying fragility of the fiscal position, which eventually led to fiscal crises and debt restructurings in such countries as Argentina and neighboring Uruguay—until then an investment grade country.

Indeed, figure 1. Figure 1. The same has held true in other emerging countries see Budina and Fiess Moreover, estimates of structural fiscal balances indicate that the improvement in fiscal conditions has not been as large as suggested by standard indicators figure 1. Furthermore, much of the fiscal adjustment achieved by most countries in the late s and early s was based on a compression of public infrastructure investment see figure 1. The ensuing decline in infrastructure capital accumulation had an adverse impact on growth, and hence the apparent improvement in fiscal health shown by standard deficit and debt indicators was, to a significant extent, only an illusion.

We next explore these two issues. Fiscal Policy and Macroeconomic Volatility: Dealing with the Procyclical Bias Macroeconomics textbooks teach that fiscal policy should be countercyclical: fiscal balances should increase in booms and decrease in recessions to smooth out fluctuations in aggregate income. Regarding fiscal policy in industrial countries, see, for instance, Lane and Wyplosz It explores the underlying causes and possible solutions. A key question is whether Latin American countries should just attempt to avoid the procyclical bias of discretionary fiscal policies, and thus.

Furthermore, some authors suggest that monetary policy should take charge of cyclical stabilization, taking as given the workings of automatic stabilizers Taylor The comparative advantage of monetary policy over fiscal policy is attributed to its shorter implementation lags, greater flexibility, and lower political constraints. So, should Latin American countries give up the use of discretionary fiscal policy and focus solely on improving automatic stabilization? If countries were to give up discretionary policies, the question is whether the automatic stabilization embedded in the cyclical position of the government budget would suffice to smooth out economic fluctuations.

If automatic stabilizers are weak or ineffective, a number of economies in the region would be left at the mercy of domestic and external shocks, with no fiscal stabilization instrument at their disposal. This would be the case of fully dollarized economies such as Ecuador, El Salvador, and. Panama, as well as the member countries of the Organization of Eastern Caribbean States OECS —which are grouped around a monetary union and therefore lack control over monetary policy. Furthermore, numerous de facto highly dollarized countries including Bolivia, Costa Rica, Guatemala, Jamaica, Nicaragua, Paraguay, Peru, and Uruguay would have to depend heavily on a feeble monetary policy to dampen business cycle fluctuations.

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Even other countries in the region with the potential to run independent monetary policies could eventually find themselves in a similar situation because of procyclical capital flows, financial sector inefficiencies, banking crises, illiquid domestic capital markets, or cost pushes. Their reliance on government spending alone, rather than both spending and revenue, is dictated by practical considerations. Most of the yearly fluctuations on the revenue side of the budget come from automatic reaction of tax revenues to the state of the economy. And in spite of the observed tax policy activism practiced by governments in Latin America, as measured by the frequency of tax reforms, the lead times required for their approval by legislatures, and the lags between enacted legal changes and their effects on actual revenues, make discretionary tax policy largely ineffective for cyclical stabilization purposes.

In contrast, spending reacts much less automatically to the cycle in Latin America as unemployment insurance payments are an insignificant fraction of budgets and, as a result, most of the observed changes are discretionary in nature. In contrast, industrial countries tend to have more countercyclical and less volatile policies. They find that macroeconomic volatility is significantly affected by discretionary fiscal policy volatility, but not by fiscal procyclicality. In turn, output growth is negatively related to macroeconomic volatility.

In summary, discretionary fiscal policy volatility increases output volatility, which in turn reduces growth prospects. The only significant and robust link between institutions and policy characteristics is the one between political constraints and policy volatility. This suggests that political constraints are able to contain the level of discretionary policy aggressiveness and thus its damaging effect on long-term growth, without affecting the responsiveness of government spending to cyclical conditions.

In this context, a positive output gap coefficient reflects countercyclical discretionary policy. The top panel of figure 1. The estimates show that the dominant trend in Latin America has been toward the pursuit of procyclical discretionary policies. In contrast, industrial countries are better able to and more effective at conducting countercyclical policy, although some of them exhibit acyclical policies, too.

The evidence of procyclical policies is more limited in industrial countries. In turn, a positive debt coefficient in the same regression indicates that discretionary policy management incorporates a debt stabilization motive. The bottom panel of figure 1. They are generally positive for both Latin America and industrial countries.

Using a similar specification, Bohn showed that a positive and at least linear response of the primary surplus-to-output ratio to the debt-to-output ratio is a sufficient condition to satisfy the long-run government budget constraint. According to this sustainability test, Latin American countries do not tighten discretionary fiscal policy when public debt ratios increase, as required for long-term sustainability.

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The Size and Role of Automatic Stabilizers Evidence presented thus far is not favorable to the use of discretionary fiscal policies in Latin America. We next examine the evidence on the size and effectiveness of automatic stabilization in the Latin American region. Income taxes and transfer payment programs built into the fiscal system are normally considered the main budgetary items acting as automatic stabilizers. The chapter focuses on the sensitivity of the budget balance to the cycle in Latin America and compares it with that found among industrial countries.

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Two cyclical sensitivity measures are used: a the estimation of tax proceeds and tax base elasticities, which is inspired by the OECD approach,6 and b an average of yearly ratios of the absolute increase in total tax revenue to the absolute increase in GDP. This is broadly consistent with two well-known additional pieces of information that, by definition, are incorporated into the construction of these indicators: a relative government size, which is much larger in industrial countries, and b the structure of taxation, which shows a larger share of income taxes in industrial countries than in Latin America.

Thus, not only has fiscal policy been procyclical in Latin America, but automatic fiscal stabilizers have been found to be weak by two alternative methods and ancillary indicators. These two features combined suggest that discretionary fiscal policy and automatic stabilizers should move in opposite directions over the business cycle in the Latin American region, and the impact of the former should override the operation of the latter.

Within industrial countries, positive correlations are commonly but not invariably observed, suggesting that the two fiscal policy components tend to reinforce each other. An additional perception of the strength of automatic stabilization or the degree of flexibility embedded in the tax system can be gained by looking at the responsiveness of automatic fiscal revenue stabilizers to changes in cyclical conditions.

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The independent variables are the same as before: the output gap, the terms of trade, the lagged stock of outstanding public debt in ratio to potential GDP, and the lagged dependent variable. As before, the regression coefficient on the output gap measures the magnitude.

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  8. Without exception, all industrial countries exhibit a statistically significant revenue response to cyclical fluctuations. In Latin America, few countries do. When the response is significant, it is much weaker than in the industrial country sample. Thus, on the whole, the region has an acyclical nondiscretionary fiscal policy. This seems to be confirmed by other results. For example, the Chilean fiscal rule has been found to have only weak smoothing effects see Perry, chapter 5 in this volume, and Fiess Finally, a quick look at Latin American data suggests that automatic revenue stabilizers fail to dampen business cycles.

    In summary, fiscal policy fails to exert a stabilizing effect. One reflection of this fact is that in Latin America there is a positive relationship between government size and output volatility, which is in contrast to the negative or flat relationship found among industrial countries figure 1. Policies and Institutions to Deal with Procyclicality The preceding sections suggest that discretionary policies in Latin America have been highly volatile, procyclical, and harmful for growth. At the same time, automatic stabilizers built into tax codes have had only a weak smoothing effect.