What Lessons Do Developing What Lessons Do Developing Countries Have for Fiscal Countries Have for Fiscal

Policy in the US?Policy in the US?

Jeffrey Frankel,Jeffrey Frankel, Professor, Harvard UniversityProfessor, Harvard University

STERN SCHOOL & INDIA PLANNING COMMISSION STERN SCHOOL & INDIA PLANNING COMMISSION WORKSHOPWORKSHOP

ON “REVIVING THE FOCUS ON LONG TERM GROWTH ON “REVIVING THE FOCUS ON LONG TERM GROWTH AND EMPLOYMENT IN THE ADVANCED ECONOMIES”AND EMPLOYMENT IN THE ADVANCED ECONOMIES”

Stern School of Business, NYU, Oct. 7-8, 2010Stern School of Business, NYU, Oct. 7-8, 2010

2

Where to look for Where to look for lessons?lessons?

• Two decades ago, many had drawn a lesson from the 1980s: Two decades ago, many had drawn a lesson from the 1980s: Japan’s variant of capitalism was the best model; Japan’s variant of capitalism was the best model; – other countries around the world should & would follow it. other countries around the world should & would follow it. – But the Japanese model quickly lost its luster in the 1990s.But the Japanese model quickly lost its luster in the 1990s.

• A decade ago, many thought that the lesson of the 1990s was A decade ago, many thought that the lesson of the 1990s was that the US variant of capitalism was the best model,that the US variant of capitalism was the best model,– that other countries should and would follow. that other countries should and would follow. – The American model lost its attractiveness in the 2000s.The American model lost its attractiveness in the 2000s.

• So, where should countries look now, in 2010, So, where should countries look now, in 2010, for models of economic success to emulate?for models of economic success to emulate?

• Perhaps to the periphery of the world economy.Perhaps to the periphery of the world economy.

3

Big lessons from small Big lessons from small countriescountries

• Some smaller and less-rich countries have experimented Some smaller and less-rich countries have experimented with policies & institutions that could usefully be adopted with policies & institutions that could usefully be adopted by some of the “advanced countries.” by some of the “advanced countries.”

• Two illustrations from microeconomics: Two illustrations from microeconomics:

– 11stst, Singapore pioneered the use of the price mechanism , Singapore pioneered the use of the price mechanism to reduce traffic congestion in its urban center. to reduce traffic congestion in its urban center.

• London emulated Singapore, successfully adopting congestion London emulated Singapore, successfully adopting congestion pricing in 2003; other big cities should do the same.pricing in 2003; other big cities should do the same.

– 22ndnd, Mexico pioneered Conditional Cash Transfer programs,, Mexico pioneered Conditional Cash Transfer programs,• making poverty benefits contingent making poverty benefits contingent on on children’s school attendance. children’s school attendance. • They have been emulated widely, embraced even in NYC.They have been emulated widely, embraced even in NYC.

4

On On the larger theme that advanced economies the larger theme that advanced economies

could learn some things from developing countriescould learn some things from developing countries • This line of argument is not meant as an attack This line of argument is not meant as an attack

on Western values or modes of thought. on Western values or modes of thought. • It is not a celebration of Confucian values It is not a celebration of Confucian values

or native folk remedies in the Andes or Africa. or native folk remedies in the Andes or Africa. • In my view, when Americans lectured others on the virtues In my view, when Americans lectured others on the virtues

of fiscal discipline, market-based economics, the rule of of fiscal discipline, market-based economics, the rule of law, and electoral democracy, they were mostly right. law, and electoral democracy, they were mostly right.

• Where they were wrong:Where they were wrong:– the failure to see that their own country needed to be the failure to see that their own country needed to be

on the receiving end just as much as developing countries,on the receiving end just as much as developing countries,• the “crony capitalism” point made famous by Simon Johnson.the “crony capitalism” point made famous by Simon Johnson.

5

Advanced economies could learn some things Advanced economies could learn some things from developing countriesfrom developing countries,, continuedcontinued

• Countries that are small, or newly independent, Countries that are small, or newly independent, or far-away, or emerging from a devastating war, or far-away, or emerging from a devastating war, are often more free to experiment, are often more free to experiment, – than is the US or other large established countries.than is the US or other large established countries.

• Not all the experiments will succeed. Not all the experiments will succeed.

• But some will. But some will.

• The results may include useful lessonsThe results may include useful lessons. .

6

Advanced economies could learn some things Advanced economies could learn some things from developing countriesfrom developing countries, , continuedcontinued

• In some cases, Western institutions were successfully In some cases, Western institutions were successfully transplanted to other countries in the past, transplanted to other countries in the past, and now needed to be re-imported.and now needed to be re-imported.

• An analogy.An analogy. – In the latter part of the 19th century In the latter part of the 19th century

the vineyards of France were destroyed by the vineyards of France were destroyed by Phylloxera vastatrix, aPhylloxera vastatrix, a microscopic aphid.microscopic aphid.

– Eventually a desperate last resort was tried: Eventually a desperate last resort was tried: grafting susceptible European vines grafting susceptible European vines onto resistant American root stock.onto resistant American root stock.

– It saved the European vineyards. It saved the European vineyards.

– The New World had come to the rescue of the Old.The New World had come to the rescue of the Old.

7

What should be the overall stance What should be the overall stance of US fiscal policy?of US fiscal policy?

• Expansionary during down-timesExpansionary during down-times– 2010. It isn’t.2010. It isn’t.

• Moving back toward discipline in up-timesMoving back toward discipline in up-times– 1993-2000. It did.1993-2000. It did.

– 2003-2007, It didn’t.2003-2007, It didn’t.

– 2012- ?2012- ?

8

The last decade has seen a historic reversal The last decade has seen a historic reversal in roles between advanced countries in roles between advanced countries and emerging/developing countries and emerging/developing countries

regarding fiscal policy.regarding fiscal policy.

• Some of the latter took advantage of the 2002-08 expansion • to run surpluses, pay down debt, • and provide for future pension costs;

• allowing budget deficits in the 2008-09 recession.• = A counter-cyclical fiscal policy

• The US, UK & some other advanced countries have forgotten how.

9

Previously, fiscal policy tended to be Previously, fiscal policy tended to be proprocyclical in developing countriescyclical in developing countries

-- that is, destabilizing:-- that is, destabilizing:

• Governments would raise spending in booms;Governments would raise spending in booms;

• and then be forced to cut back in downturns.and then be forced to cut back in downturns.• Kaminsky, Reinhart & Vegh Kaminsky, Reinhart & Vegh (2004),(2004), Talvi & Végh Talvi & Végh (2005),(2005),

Alesina, Campante & TabelliniAlesina, Campante & Tabellini ((2008),2008), Mendoza & Oviedo Mendoza & Oviedo (2006),(2006), Ilzetski & Vegh Ilzetski & Vegh (2008)(2008) and Medas & Zakharova and Medas & Zakharova (2009).(2009).

• Especially Latin American commodity-producersEspecially Latin American commodity-producers..• Gavin & Perotti Gavin & Perotti (1997),(1997), Calderón & Schmidt-Hebbel Calderón & Schmidt-Hebbel (2003)(2003) and Perry and Perry

(2003).(2003).

10

Kaminsky, Reinhart & Vegh (2004)

GG always used to be pro-cyclical always used to be pro-cyclical for most developing countries.for most developing countries.

Correlations between Gov.t Spending & GDPCorrelations between Gov.t Spending & GDP}pro

cyc

lica

lcou

nte

rcyc

lica

l

11

The historic reversal in developing countriesThe historic reversal in developing countries

• Over the last decade many emerging market countries finally Over the last decade many emerging market countries finally developed developed countercyclicalcountercyclical or stabilizing fiscal policies: or stabilizing fiscal policies:

• They took advantage of the boom years 2003-2008 They took advantage of the boom years 2003-2008 – to run budget primary to run budget primary surplusessurpluses..– By 2007, Latin America had reduced its debt to 33% of GDP, By 2007, Latin America had reduced its debt to 33% of GDP,

• as compared to 63 % in the United States. as compared to 63 % in the United States.

• Debt levelsDebt levels among top 20 rich countries among top 20 rich countries (debt/GDP ratios ≈ 80%) (debt/GDP ratios ≈ 80%) are now twice those of the top 20 emerging marketsare now twice those of the top 20 emerging markets . .

• Some emerging markets have earned Some emerging markets have earned credit ratingscredit ratings higher than some so-called advanced countries.higher than some so-called advanced countries.

– Korea now has a better credit rating that Portugal. Korea now has a better credit rating that Portugal. – Not only Chile & China, but also Malaysia, Mexico, Poland & South Africa, now have higher credit ratings than Greece or Iceland.Not only Chile & China, but also Malaysia, Mexico, Poland & South Africa, now have higher credit ratings than Greece or Iceland.

• As a result these countries were able to ease budgets As a result these countries were able to ease budgets in 2008-09, helping recovery from the recession.in 2008-09, helping recovery from the recession.

12

Two stories of the past decade:Two stories of the past decade:One set in U.S., the other in One set in U.S., the other in

ChileChile

• When the Bush administration took office in January 2001,When the Bush administration took office in January 2001,

it forecast $5 trillion in cumulative budget surpluses for the decade.it forecast $5 trillion in cumulative budget surpluses for the decade.

• One component of this over-optimistic forecast:One component of this over-optimistic forecast:An incoming political appointee at OMB raised an obscure parameter An incoming political appointee at OMB raised an obscure parameter – the share of labor income in GDP – – the share of labor income in GDP – from its long-time technocratic (CEA) estimate.from its long-time technocratic (CEA) estimate.

Story #1: US fiscal policyStory #1: US fiscal policy

13

Budget forecasts by the Bush Budget forecasts by the Bush White House then had to be White House then had to be

revised down every yearrevised down every year

Jan.2001

Aug.2001

Jan.2002

Aug.2002

Jan.2003

Aug.2003

Jan.2004

-500

-400

-300

-200

-100

0

100

200

300

400U

S$ b

n

2002 2003 2004Source: OMB

14

US fiscal policy over the past decade,US fiscal policy over the past decade, continuedcontinued

• The forecasted surpluses helped Bush launch The forecasted surpluses helped Bush launch a 10-year path of irresponsible fiscal policy:a 10-year path of irresponsible fiscal policy:– tax cuts tax cuts – & accelerated spending & accelerated spending

• > twice Clinton’s rate of spending growth.> twice Clinton’s rate of spending growth.

• The results:The results:

– a cumulative $5 trillion in decade budget a cumulative $5 trillion in decade budget deficitsdeficits..

– Today, in 2010, despite a weak economy, Today, in 2010, despite a weak economy, Washington feels constrained by its debt Washington feels constrained by its debt to withdrawal fiscal stimulus.to withdrawal fiscal stimulus.

15

Story #2: Chile in 2000 Story #2: Chile in 2000 instituted a structural instituted a structural

budget rulebudget rule• The institution was formalized in law in 2006.The institution was formalized in law in 2006.• The rule: the structural budget deficit must be zero,The rule: the structural budget deficit must be zero,• where structural is defined as output & copper price where structural is defined as output & copper price

equal to their long-run trend values.equal to their long-run trend values.

• I.e., in a boom the government I.e., in a boom the government can only spend increased revenues can only spend increased revenues that are deemed permanent; that are deemed permanent; any temporary copper bonanzas any temporary copper bonanzas much be saved.much be saved.

16

• Chile’s fiscal position strengthened immediately. Chile’s fiscal position strengthened immediately. – allowing national saving to rise from 20.6% to 23.6% by 2005.allowing national saving to rise from 20.6% to 23.6% by 2005.

• Government debt fell sharply as a share of GDP Government debt fell sharply as a share of GDP and the sovereign spread gradually declined. and the sovereign spread gradually declined.

• By 2006, Chile achieved a sovereign debt rating of A, By 2006, Chile achieved a sovereign debt rating of A, – several notches ahead of Latin American peers.several notches ahead of Latin American peers.

• By 2007 Chile had become a net creditor. By 2007 Chile had become a net creditor. • By June 2010, its sovereign rating had climbed to A+, By June 2010, its sovereign rating had climbed to A+,

– ahead of some advanced countries: ahead of some advanced countries:

– Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).

17

• By 2008. with copper prices spiking upward, By 2008. with copper prices spiking upward, the government of President Bachelet was the government of President Bachelet was under intense pressure to spend the revenue.under intense pressure to spend the revenue.– She & Fin.Min.Velasco held to the rule, saving most of it.She & Fin.Min.Velasco held to the rule, saving most of it.– Their popularity ratings reached historic lows.Their popularity ratings reached historic lows.

• When the recession hit and the copper price came When the recession hit and the copper price came back down, the government increased spending, back down, the government increased spending, mitigating the downturn.mitigating the downturn.– The Ministers’ popularity The Ministers’ popularity

reached historic reached historic highshighs in 2009. in 2009.

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• A budget target of zero may sound familiarA budget target of zero may sound familiar– like the budget deficit ceilings that like the budget deficit ceilings that

supposedly constrain members of euroland supposedly constrain members of euroland (deficits < 3 % of GDP under (deficits < 3 % of GDP under the Stability & Growth Pact) the Stability & Growth Pact)

– or like the occasional U.S. proposals or like the occasional U.S. proposals for a Balanced Budget Amendment (deficit = 0).for a Balanced Budget Amendment (deficit = 0).       

• But those attempts have failed, But those attempts have failed, because they are too rigid to allow because they are too rigid to allow the need for deficits in recessions, the need for deficits in recessions, counterbalanced by surpluses in good times.counterbalanced by surpluses in good times.

• Specifying the budget rule in structural terms does Specifying the budget rule in structural terms does not solve the problem, if politicians are the ones not solve the problem, if politicians are the ones who judge what is structural and what is cyclical.who judge what is structural and what is cyclical.    

19

Budget balance forecast error as % of GDP, Full dataset

(1) (2) (3)

One year ahead Two years ahead Three years ahead

GDP relative to trend

0.093***(0.019)

0.258***(0.040)

0.289***(0.063)

Constant 0.201 0.649*** 1.364***(0.197) (0.231) (0.348)

Observations 398 300 179Variable is lagged so that it lines up with the year in which the forecast was made.*** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country.

Official budget forecasts are biased toward optimismespecially if GDP is currently high & especially at longer horizons

33 countries

20

Budget balance forecast error as a % of GDP, Full Dataset(1) (2) (3) (4)

One year ahead

Two years ahead

One year ahead

Two years ahead

SGPdummy 0.658 0.905** 0.407 0.276(0.398) (0.406) (0.355) (0.438)

SGP dummy * (GDP - trend)

0.189**(0.0828)

0.497***(0.107)

Constant 0.0330 0.466* 0.0330 0.466*(0.228) (0.248) (0.229) (0.249)

Observations 399 300 398 300

Official budget forecasts are more biased toward optimismin countries subject to a budget deficit rule (SGP)

*** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country.

33 countries

21

The crucial institutional innovation in ChileThe crucial institutional innovation in Chile

• How has Chile avoided over-optimistic official forecasts?How has Chile avoided over-optimistic official forecasts?– especially the historic pattern of especially the historic pattern of

over-exuberance in commodity booms?over-exuberance in commodity booms?

• The estimation of the long-term path The estimation of the long-term path for GDP & the copper price for GDP & the copper price -- and so how much of a copper bonanza can be spent -- -- and so how much of a copper bonanza can be spent -- is made by two panels of independent experts,is made by two panels of independent experts,– and thus is insulated from political pressure & wishful thinking.and thus is insulated from political pressure & wishful thinking.

• Other countries could usefully emulate Chile’s innovationOther countries could usefully emulate Chile’s innovation– or in other ways delegate to independent agencies or in other ways delegate to independent agencies

estimation of structural budget deficit paths.estimation of structural budget deficit paths.

22

The US public discussion is framed like a battle between The US public discussion is framed like a battle between conservatives who philosophically believe in strong conservatives who philosophically believe in strong

budgets & small government, and liberals who do not. budgets & small government, and liberals who do not.

Not the right way to characterize the debateNot the right way to characterize the debate . . [1][1]

• (1) The right goal should be budgets that allow (1) The right goal should be budgets that allow surpluses in booms and deficits in recession.surpluses in booms and deficits in recession.

• (2) The correlation between how loudly an American (2) The correlation between how loudly an American politician proclaims a belief in fiscal conservatism politician proclaims a belief in fiscal conservatism and how likely he is to take corresponding policy steps and how likely he is to take corresponding policy steps < 0< 0..

[1][1] Forget that small government is classically supposed to be Forget that small government is classically supposed to be the aim of “liberals,” in the 19th century definition, not “conservatives.” the aim of “liberals,” in the 19th century definition, not “conservatives.” My point is different: those who call themselves conservatives in practice tend to My point is different: those who call themselves conservatives in practice tend to adopt policies that are the opposite of fiscal conservatism. I call them “illiberal.” adopt policies that are the opposite of fiscal conservatism. I call them “illiberal.” “Republican & Democratic Presidents Have Switched Economic Policies”“Republican & Democratic Presidents Have Switched Economic Policies”     Milken Milken Inst.RevInst.Rev.. 2003.2003.

23

Three pieces of evidence to support the claim Three pieces of evidence to support the claim that “fiscal conservatives” are not:that “fiscal conservatives” are not:

• (i(i) The voting pattern among the 258 Congressmen ) The voting pattern among the 258 Congressmen who signed an unconditional pledge not to raise taxes:who signed an unconditional pledge not to raise taxes:– As of 2004, they had voted for more spending As of 2004, they had voted for more spending

than those who did not sign the pledge. than those who did not sign the pledge. [2][2]

• (ii) The pattern of spending (ii) The pattern of spending under Republican presidents.under Republican presidents.[3][3]

• (iii) The pattern of states whose Senators win pork (iii) The pattern of states whose Senators win pork & other federal spending.& other federal spending. [4][4]

• [2][2] William Gale & Brennan Kelly, 2004, “William Gale & Brennan Kelly, 2004, “The ‘No New Taxes’ PledgeThe ‘No New Taxes’ Pledge,” ,” Tax NotesTax Notes, July, July.. • [3][3] JF JF “Snake-Oil Tax Cuts,“Snake-Oil Tax Cuts,” ”   EPIEPI, , Briefing Paper 221Briefing Paper 221. 2008. . 2008. • [4] [4] JF JF Red States, Blue States and the Distribution of Federal SpendingRed States, Blue States and the Distribution of Federal Spending, 3/31/2010., 3/31/2010.

24

Vs. the 1990s: The Shared Sacrifice approach succeeded in Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spendingeliminating budget deficits, importantly by slowing spending. .

-3

-1

1

3

5

7

9

11

13

15

10

12

14

16

18

20

22

24

19

77

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

Est

20

09

Est

20

10

Est

Spending and Budget Balance(inverse) as % of GDP (Current US$)

Spending/GDP Budget Balance/GDP

R. R

ea

ga

n

J. C

art

er

G.H

.W.

Bu

sh

W.J

. C

lin

ton

G.W

.Bu

sh

Source: OMB

ρ = 0.86

(ii) Spending & deficits both rose sharply when (ii) Spending & deficits both rose sharply when Presidents Reagan, Bush I, & Bush II took office.Presidents Reagan, Bush I, & Bush II took office.

25

(iii) States ranked by federal (iii) States ranked by federal spending receivedspending received

per tax dollar paid in 2005per tax dollar paid in 2005versus party vote ratio in preceding versus party vote ratio in preceding electionelection

Republican states take home Republican states take home significantly more federal $ significantly more federal $ (relative to taxes paid)(relative to taxes paid) than Democratic statesthan Democratic states

“red”states

“blue”states low inflow of US $

big inflow of US $

26

U.S. fiscal policy in 2010-2011?U.S. fiscal policy in 2010-2011?• What changes in American fiscal policy What changes in American fiscal policy

would be desirable at the current juncture,would be desirable at the current juncture, – if politics were not an obstacle? if politics were not an obstacle?

• On the one hand, the economy is still weak. On the one hand, the economy is still weak. • On the other hand, the U.S. can’t wait until the recovery On the other hand, the U.S. can’t wait until the recovery

is complete to tackle the long run fiscal problem. is complete to tackle the long run fiscal problem.

• A two-part strategy:A two-part strategy:• Current steps to extend the fiscal stimulus, Current steps to extend the fiscal stimulus,

– designed to maximize bang for the buck.designed to maximize bang for the buck.

• Current steps to lock in future progress Current steps to lock in future progress back toward fiscal discipline in the long run.back toward fiscal discipline in the long run.

27

U.S. fiscal policy in 2010-2011U.S. fiscal policy in 2010-2011, continued, continued

• Maximizing bang for the buck ≡ fiscal stimulus that Maximizing bang for the buck ≡ fiscal stimulus that gives the most demand per $ added to long-term debt.gives the most demand per $ added to long-term debt.

• Example that would Example that would minimizeminimize bang for the buck: bang for the buck: – proposal to make permanent the 2010 estate tax abolition. proposal to make permanent the 2010 estate tax abolition. – Also poorly targeted: proposal to prevent the Bush tax cuts Also poorly targeted: proposal to prevent the Bush tax cuts

from expiring in 2011 for those households > $250,000. from expiring in 2011 for those households > $250,000.

• If the stimulus has to take the form of tax cuts, If the stimulus has to take the form of tax cuts, then the best options are:then the best options are:– extending President Obama’s “Make Work Pay” tax cuts, extending President Obama’s “Make Work Pay” tax cuts, – fixing the Alternative Minimum Tax, and fixing the Alternative Minimum Tax, and – extending the Bush tax cuts for those households < $250,000. extending the Bush tax cuts for those households < $250,000. – Some business tax cuts could also give high bang for the buck. Some business tax cuts could also give high bang for the buck.

• such as temporary credits for investment or hiring.such as temporary credits for investment or hiring.

28

U.S. fiscal policy in 2010-2011U.S. fiscal policy in 2010-2011, continued, continued

• But spending boosts demand more than tax cuts do, But spending boosts demand more than tax cuts do, – because the latter are partly saved.because the latter are partly saved.

• Extend elements of the Obama stimulus Extend elements of the Obama stimulus – such as infrastructure investment and such as infrastructure investment and – giving money to the states giving money to the states

• so that they don’t have to lay off teachers, policemen, so that they don’t have to lay off teachers, policemen, firemen, subway drivers & construction workers.firemen, subway drivers & construction workers.

29

U.S. fiscal policy in 2010-2011U.S. fiscal policy in 2010-2011, continued, continued

• How does one take steps today How does one take steps today to lock in future fiscal consolidation? to lock in future fiscal consolidation?

– Not by raising taxes or cutting spending today Not by raising taxes or cutting spending today (see above); (see above);

– nor by promising to do so in a year or two nor by promising to do so in a year or two (not credible).(not credible).

– There are lots of economically sensible proposalsThere are lots of economically sensible proposals

• for spending to eliminate, for spending to eliminate,

• more efficient taxes to switch to, more efficient taxes to switch to,

• and “tax expenditures” to cut. and “tax expenditures” to cut.

30

U.S. fiscal policy in 2010-2011U.S. fiscal policy in 2010-2011, continued, continued

• One big reform might work best: One big reform might work best: pass legislation today to put Social Security pass legislation today to put Social Security on a sound financial footing in the long term. on a sound financial footing in the long term.

• It would consist of a combination It would consist of a combination – of raising the retirement age of raising the retirement age

• just a little (in proportion to lengthening life spans) just a little (in proportion to lengthening life spans)

– and slowing the growth of benefits for future retirees and slowing the growth of benefits for future retirees • just a little (perhaps by “progressive indexation). just a little (perhaps by “progressive indexation).

• If Washington could fix Social Security, If Washington could fix Social Security, – it would address the long-term fiscal outlook,it would address the long-term fiscal outlook,

– yet would create no drag on the current fragile recoveryyet would create no drag on the current fragile recovery..

31

32

AppendicesAppendices

• Econometric tests of hypotheses Econometric tests of hypotheses regarding bias toward optimism in regarding bias toward optimism in official budget forecasts. official budget forecasts.

• The political success of the Chilean The political success of the Chilean government’s fiscal strategy, 2008-09.government’s fiscal strategy, 2008-09.

33

Econometrically supported hypotheses Econometrically supported hypotheses regarding bias toward optimism in regarding bias toward optimism in

official budget forecasts.official budget forecasts.

• Official forecasts of budgets & GDP in a sample Official forecasts of budgets & GDP in a sample of 33 countries are overly optimistic on average.of 33 countries are overly optimistic on average.

• The bias is stronger the longer the forecast horizon.The bias is stronger the longer the forecast horizon.• The bias is greater among European governments that The bias is greater among European governments that

are politically subject to the budget rules in the SGP.are politically subject to the budget rules in the SGP.• The bias toward optimism is greater at the extremes The bias toward optimism is greater at the extremes

of the business cycle, particularly in booms.of the business cycle, particularly in booms.• The key macroeconomic input for budget forecastingThe key macroeconomic input for budget forecasting

in most countries: GDP. In Chile: the copper price.in most countries: GDP. In Chile: the copper price.

34

Econometrically supported hypotheses regarding bias Econometrically supported hypotheses regarding bias toward optimism in official budget forecasts, toward optimism in official budget forecasts, continued.continued.

• Real copper prices mean-revert in the long run, Real copper prices mean-revert in the long run, – but this is not always readily perceived. but this is not always readily perceived.

– A mere 30 years of data cannot reject a random walk.A mere 30 years of data cannot reject a random walk.

• Uncertainty Uncertainty (option-implied volatility)(option-implied volatility) is higher when is higher when copper prices are toward the top of the cycle.copper prices are toward the top of the cycle.

• Chile’s official forecasts are not overly optimistic.Chile’s official forecasts are not overly optimistic.

• Chile has apparently avoided the problem of official Chile has apparently avoided the problem of official forecasts that unrealistically extrapolate in boom times.forecasts that unrealistically extrapolate in boom times.

35

Poll ratings of Chile’s President over time

Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009

In 2009, the popularity of the Socialist President of Chile Michelle Bacheletrose sharply (both with respect to handling of the economy and overall), to the highest levels since the restoration of democracy 20 years earlier.

More remarkable: the rise in the polls, from very low to very high, came just as the economy moved from rapid growth to slow growth -- not the usual pattern. Why?

36

And the Finance Minister?: August 2009

Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009

Poll ratings of Chile’s

Presidents and Finance

Ministers

In August 2009, the popularity of the Finance Minister, Andres Velasco,

ranked behind only President Bachelet, despite also having been low two years

before. Why?