Monday, April 23, 2012

Fiscal policy Rules - Chilean experience

Arguably the biggest short-term challenge facing the Government of India is to get its fiscal balance in order. With elections due in two years, the propsects of any significant roll-back on subsidies, the major contributor to the fiscal imbalance, appears bleak. However, at a policy level what are the options available for the government to address this challenge?

The ultimate objective of any fiscal policy framework is to maintain long-term budget balance. In the long-run this can be achieved only by running up surpluses during the good times so as to build up the buffer to draw upon when the economy hits rough weather. But real world implementation of such counter-cyclical fiscal policy is difficult in democracies. As the good times arrive and tax revenues soar, pressure inevitably builds to spread it around. Not many countries have successfully managed this challenged.

The most famous experiment with fiscal policy rules is the European Union's Stability and Growth Pact, which defined a budget deficit target of 3% of GDP, beyond which defaulters could attract steep fines. It was thought that the clear target and the severity of the fines would deter countries from defaulting. But as we have seen over the past decade, this target was rarely met, even by its more fiscally prudent members.

Closer home, India's own experiment with fiscal policy rules has been disappointing. The Fiscal Responsibility and Budget Management (FRBM) Act was enacted in 2003 with the objective of eliminating revenue deficit and bringing down fiscal deficit to 3% of GDP by March 2008. However, the sub-prime crisis and the global economic slowdown resulted in the suspension of its implementation in 2009. In the context of India's dismal fiscal balance, there have been calls from within the government for reviving the FRBM.

However, Chile, as in many other cases of macroeconomic policy making, stands out as an excellent example of successful fiscal management. Since 2000, Chile has managed a truly counter-cyclical fiscal policy through a set of very clearly defined fiscal policy rules. At the heart of its fiscal policy framework is a clear budget target. The budget target was originally set as a surplus amounting to 1% of GDP, but was lowered to 0.5% in 2007 and to 0% in 2009. The government is permitted to run a deficit larger than the target only if the output falls short of its long-run trend (say, in a recession) or if the price of copper (it accounts for 16% of government's income) falls below its medium-term (10 year) equilibrium. Jeffrey Frankel writes,
The key institutional innovation is that there are two 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. The experts on the copper panel are drawn from mining companies, the financial sector, research centers, and universities. The government then follows a set of procedures that translates these numbers, combined with any given set of tax and spending parameters, into the estimated structural budget balance. If the resulting estimated structural budget balance differs from the target, then the government adjusts spending plans until the desired balance is achieved.
He writes about how the government of Michelle Bachelet (2006-2010) instututionalized the structural budget rule (it was initially followed voluntarily by the government of Ricardo Lagos) into a Fiscal Responsibility Bill 2006 and resisted the temptation to indulge in public spending when copper prices boomed. 
The real test of the policy came during the latter years of the copper boom of 2003-2008 when, as usual, the political pressure was to declare the increase in the price of copper permanent thereby justifying spending on a par with export earnings. The expert panel ruled that most of the price increase was temporary so that most of the earnings had to be saved. This turned out to be right, as the 2008 spike indeed partly reversed the next year. As a result, the fiscal surplus reached almost 9% when copper  prices were high. The country paid down its debt to a mere 4 % of GDP and it saved about 12 % of GDP in the sovereign wealth fund. This allowed a substantial fiscal easing in the recession of 2008-09, when the stimulus was most sorely needed.
As indicated, the critical innovation in Chile was the clear identification of budget-relevant macroeconomic variables (output gap and copper prices), entrustment of its estimation to independent panels, and the fortification of this framework as a statutory mandate. This approach to fiscal policy making has the twin-benefits of letting a technocratic agency determine the outer boundaries of the fiscal balance at any time, while leaving elected governments with the freedom to allocate spending among competing claims. However, as is the case with all such neat solutions, the challenge lies with its political acceptability.

One encouraging sign as we set out in this pursuit of fiscal policy rules comes from the evolution of central banks and their monetary policy making role. We often take for granted the independence and objectivity of monetary policy decisions. This glosses over the fact that independent, target-focussed and rules-driven monetary policy decisions by central banks is, even in developed economies, a recent phenomenon. In countries like India, central banks have gained tremendous authority and credibility in their interest rate decisions over the past decade or so. Governments have exercised great caution and restraint in promoting central bank autonomy. There is some reason to hope that fiscal policy rules too could similarly evolve and gain strength over a period of time.

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