Latin America’s Economy — Why This Is No Time For Complacency

By Eric Parrado

A young Augustine, before becoming a Saint, lived a hedonistic lifestyle. But one day he received a message from God – asking him to convert from that type of life. So he prayed to God: “Lord, grant me chastity and continence …but not yet.” Many times governments behave like St. Augustine as they know that changing to a prudent fiscal policy is better for national welfare, but at the same time do not have the desire or the courage to make that change. This is what we can call the St Augustine Syndrome – and countries should avoid it.

Over the past quarter-century, Chile has proven that it is possible to avoid the St. Augustine Syndrome: a middle-income, natural resource-producing nation can follow a fiscal policy that is both stable and sustainable. The core of this policy has been very simple: act responsibly all the time, design policies for the long run, and accumulate enough fiscal space so that fiscal policy can play a stabilizing role in the short run. It sounds easy, but this requires not only economic responsibility, but political courage. From this experience some lessons could be useful for other countries in any stage of development.

The approach requires saving money during economic booms and using those accumulated resources during inevitable slowdowns. Shifting from a pro-cyclical to a counter-cyclical (or acyclical) fiscal stance stabilises both relative prices and economic activity. It also has important political effects, helping smooth public investment and social expenditures across the cycle, and shielding welfare programmes and transfers to the poor from the moods of the commodities markets.

One example of this is Chile’s reaction to the 2008-09 global financial crisis. The collapse of Lehman Brothers occurred while Chile’s public debt was miniscule. The country also had large cash reserves and well-capitalized banks. As a result, the government was able to put together a sizeable anti-crisis fiscal package, while the Central Bank slashed interest rates significantly. Never before in Chile’s history had such an aggressively counter-cyclical macro stance been feasible. The results were encouraging: the recession was shallow and short-lived.

Based on this positive experience, Chile’s approach contains ideas and practices that could be useful in the design of fiscal policies and institutions in other commodity-producing nations. In particular, a comprehensive fiscal policy framework should include two main instruments; one that deals with flow management (fiscal rules) and one that considers stock management (Sovereign Wealth Funds – or SWFs).

In order to smooth expenditure flows and tax distortions over time, governments should optimally run surpluses in good times (rapid economic growth, high commodity prices) and temporary deficits in bad times. In other words, the budget should not necessarily be balanced every year, but it should be in balance over the business cycle.

Under a fiscal rule, annual fiscal expenditure has a ceiling that is similar to the central government’s long-term or structural revenue, irrespective of income fluctuations caused by cyclical fluctuations in economic activity, the prices of main export commodities, and other variables that determine effective fiscal income.

Thus, governments can save during upswings and stop saving during downturns. In this way they can avoid two main issues: surges in spending when commodity prices rise and the economy picks up and drastic tightening of fiscal spending when commodity prices drop and the economy slows.

To arrive at a definition of long-term or structural income, fiscal rules usually use the long-term price of the main commodities and the trend growth of GDP. In other words, it is important to identify all sources of revenues both taxable and non-taxable. To avoid any political biases in the estimation of these values, the estimation of the long-term prices of commodities and the GDP trend could be entrusted to independent committees of experts. For the ceiling to be politically legitimate, the regime for setting that ceiling has to be simple and predictable.

Ideally, the fiscal rule framework should be enshrined in law, leaving flexibility to governments to set the specific parameters regarding the deviation of expenditures from the long-term revenues.

The existence of a publicly acknowledged system also helps individual politicians to explain to their constituents why a particular spending item may not receive as much funding as they might have desired.

The application of a fiscal rule could imply substantial fiscal savings (in good economic times), which had to be managed somehow. Hence, fiscal responsibility laws could create the legal framework for the application of fiscal rules and establish SWFs as vehicles for managing the surplus. The issues that must be considered in setting a SWF are as follows: clear objectives, strict capital contributions and withdrawals rules, strong governance and institutional framework, prudent investment policy, and a transparent communications policy and accountability.