Fiscal prudence dictates that governments run counter-cyclical fiscal policy where they reduce overall debt when the economy is operating above its average growth trend and run up debts when the economy is running at below average growth so as to smooth over declines in aggregate demand. Jeffrey Frankel draws attention to Chile's achievement in effectively managing its long-term budget balance by resorting to prudent counter-cyclical fiscal measures.
At the risk of lowering its popularity, the government of Michelle Bachelet had resisted intense pressure to spend the soaring receipts from increases in copper exports and steep rises in their prices on populist expenditures. However, when the recession stuck and despite the fall in copper prices, the government drew down the assets that it had acquired during the copper boom and increased spending sharply, and thereby succeed in moderating the downturn.
This classic case of successful implementation of counter-cyclical fiscal policy was underpinned by the presence of the required institutional framework and strict fiscal rules (target for the overall budget surplus at 0.5% of GDP). The government introduced a Fiscal Responsibility Bill in 2006, which gave legal force to the role of the structural budget, and created a Pension Reserve Fund and a Social and Economic Stabilization Fund, the latter a replacement for the existing Copper Stabilization Funds. As Prof Frankel writes, under the Chilean rules, the government can run a deficit larger than the target to the extent that
1. Output falls short of potential, in a recession, or
2. The price of copper is below its medium-term (10-year) equilibrium
Interestingly, there are two institutionalized panels of experts whose job it is each mid-year to make the judgments, respectively, what is the output gap and what is the medium term equilibrium price of copper. This effectively de-politicized the decision to run large fiscal deficits. The panels rightly ruled during the copper boom of 2003-08 that most of the price increase was temporary so that most of the earnings had to be saved.
Prof Frankel suggests that countries, especially commodity producers, could apply variants of the Chilean fiscal device. He writes,
"Given that many developing countries are more prone to weak institutions, a useful reinforcement of the Chilean idea would be to give legal independence to the panels. There could a requirement regarding the professional qualifications of the members and laws protecting them from being fired, as there are for governors of independent central banks. The principle of a separation of decision-making powers should be retained: the rules as interpreted by the panels determine the total amount of spending or budget deficits, while the elected political leaders determine how that total is allocated."
Mark Thoma compares such institutional interventions to a form of Taylor Rule for fiscal policy. See also Mostly Economics.
The second shining example throughout the ongoing turmoil has been Canadian financial markets. As Paul Krugman argues, Canada faced much the same domestic and external environments in the lead up to the crisis as the US - loose money policies and robust economic growth at home and a "flood of cheap goods and cheap money from Asia". Like the six "too-big-to-fail" financial firms in the US, the Canadian financial market landscape is dominated by five banking groups. But when the bubble burst, unlike the US, in Canada mortgage defaults did not soar, major financial institutions did not collapse, and there were very few bailouts.
Canada's success lay in more effective regulation which included "much stricter limits on leverage, much stricter limits on unconventional mortgages, and an independent consumer protection agency for borrowers" and its adherence to "boring banking" to keep bankers honest. Canada's independent Financial Consumer Agency had sharply restricted subprime-type lending and its bank regulators had placed well-defined limits on securitization by requiring that lenders hold on to some of their loans.
See also this post on the parallel between the long-term unemployment in the US now and "unpleasant parallels to Canada's experience of the 1990's".
Update 2 (25/3/2010)
Simon Johnson and Peter Boone disagrees that Canada provides an example of better regulation. Canada has five mega TBTF banks who ran up higher leverage (average of 19 times levered) than the big six US TBTF banks. Their capital requirements - both Tier One capital and tangible common equity ratios - were lower than US banks and were therefore less capitalized. However, all of them enjoyed guarantees provided by the government of Canada (over half of Canadian mortgages are effectively guaranteed by the government), especially on their mortgages (just like Fannie Mae & Co, who however did relax their lending standards and slipped into trouble).