10-17-2013 09:57 AM

Fiscal policy: Learning to (push against the) cycle

FINANCIAL markets are currently pummelling developing countries for their poor economic management. For instance, India has been criticised for its profligate fiscal policy—which left it vulnerable to the market turmoil prompted by the threat of Fed tapering. Brazil's way out of the 2008-09 crisis was ham-fisted at best.*
Many developing countries have made mistakes. But over the longer term, they have made commendable improvements in economic management. A new paper* (no paywall here) looks at the “cyclicality” of fiscal policy in emerging markets—in plain English, how the government varies spending and taxation during the business cycle. And its conclusions are heartening.*

Most economists favour at least passively countercyclical fiscal policies. During periods of economic strength, they argue, a government should be restrained in its spending, lest it turn a healthy economy into an unsustainably booming one. Even better: with the money it saves during the good times, it can soften the blow during bad.*
But the paper starts by showing a rather depressing graph (see below right). From 1960-1999, there was a positive correlation between government expenditure and real GDP for the vast majority of developing countries (developed countries, on the other hand, generally saw a negative correlation). In other words, during recessions, developing-country governments tightened the purse strings; during booms, spending was wild.
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Procyclical fiscal policy developed for a number of reasons. Political pressures played a role. During boom times, finance ministers found it difficult to hold government spending back in the face of massive demand. By the time the economy soured, there was little fiscal room; tightening was required. In political-science jargon, “institutional quality” was poor; governments conducted ill-disciplined fiscal policy.
Others argue that capital markets were unfriendly towards developing countries. Especially during a downturn it was difficult to borrow. That meant that government spending had to be cut back—and taxation increased—just as the economy needed exactly the opposite.*
But over the past few years, developing countries have got better at using countercyclical fiscal policies. As Jeffrey Frankel shows, Chile is a prime example. Copper accounts for about 16% of Chile’s fiscal income. Higher copper prices result in higher government revenues. And so past Chilean governments were sorely tempted to make overoptimistic predictions about the future copper price, thereby allowing them to embark on bulky spending programmes.*
But Chile created an independent panel which was charged with predicting future copper prices. From 2003-08, the panel argued that copper price increases were temporary—thereby preventing the government from letting spending run wild during the commodity boom. The fiscal surplus reached almost 9% when the price of copper was high, which allowed for fiscal room when the financial crisis hit. Improved institutional quality led to better fiscal policy.*
And other developing countries have been implementing similar reforms. Whereas from 1960-1999, almost all developing countries displayed procyclical fiscal policies, a decent number were using countercyclical policies instead from 2000 to 2009 (see below).
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The authors’ calculations show that better institutions leads to more countercyclical fiscal policy. Many developing countries are in a mess right now, but many have made real improvements to their economic management in recent years.*
*Frankel, J. A., Vegh, C. A., & Vuletin, G. (2013). 'On graduation from fiscal procyclicality'.*Journal of Development Economics,*100(1) 32-47.*




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