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A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile

CID Working Paper No. 216

Jeffrey Frankel
January 2011

Abstract

Historically, many countries have suffered a pattern of procyclical fiscal policy: spending too much in booms and then forced to cut back in recessions, thereby exacerbating the business cycle. This problem has especially plagued Latin American commodity-producers. Since 2000, fiscal policy in Chile has been governed by a structural budget rule that has succeeded in implementing countercyclical fiscal policy. The key innovation is that the two most important estimates of the structural versus cyclical components of the budget – trend output and the 10-year price of copper – are made by expert panels and thus insulated from the political process. Chile’s fiscal institutions could usefully be emulated everywhere, but especially in other commodity-exporting countries.

This paper finds statistical support for a series of hypotheses regarding forecasts by official agencies that have responsibility for formulating the budget.

  1. Official forecasts of budgets and GDP in a 33-country sample are overly optimistic on average.
  2. The bias toward over-optimism is stronger the longer the horizon
  3. The bias is greater among European governments that are politically subject to the budget rules in the Stability and Growth Pact (SGP).
  4. The bias is greater at the extremes of the business cycle, particularly in booms.
  5. In most countries, the real growth rate is the key macroeconomic input for budget forecasting. In Chile it is the price of copper.
  6. Real copper prices mean-revert in the long run, but this is not always readily perceived.
  7. Chile’s official forecasts are not overly optimistic on average.
  8. Chile has apparently avoided the problem of official forecasts that unrealistically extrapolate in boom times.

The conclusion is that official forecasts, if not insulated from politics, tend to be overly optimistic, and that the problem can be worse when the government is formally subject to a budget rule. The key innovation that has allowed Chile in general to achieve countercyclical fiscal policy, and in particular to run surpluses in booms, is not just a structural budget rule in itself, but rather the regime that entrusts to panels of independent experts the responsibility for estimating the extent to which contemporaneous copper prices and GDP have departed from their long-run averages.

Keywords: budget rules, copper, Chile, commodity boom, countercyclical, Dutch Disease, fiscal policy, structural budget, institutions, natural resource curse, procyclical, Stability and Growth Pact

JEL subject codes: E62, F41, H50, O54, Q33