Escape from Procyclicality: Fiscal Policy in Developing Countries

[This column is co-authored with Carlos Végh and Guillermo Vuletin and was published in VoxEU.]

Everywhere one looks, problems of fiscal policy are now center stage.   Among advanced countries, the news is bad:   Europe’s periphery teeters, the U.K. slashes, the U.S. deadlocks, Japan muddles.  But in the rest of the world there is better news:   In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.

In the past, developing countries tended to follow procyclical fiscal policy:   they increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession.  Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialized countries that has been by and large countercyclical. (References for this proposition and others are available.)   Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle.  Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or even more than proportionately. One can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.

Figure I (which is a version of evidence presented in Kaminsky, Reinhart and Vegh, 2004) depicts the correlation between government spending and GDP for 94 countries over the period 1960-1999.   More precisely, it shows the correlation between the cyclical components of spending and GDP;  the longer term trends are taken out.   The set includes 21 developed countries, which are represented by black bars, and 73 developing countries, represented by yellow bars.  A positive correlation indicates government spending that is procyclical, that is, destabilizing.  A negative correlation indicates countercyclical spending, that is, stabilizing.

Figure I

[Click here for enlargement of Figure I.]

There is no missing the message.  Yellow bars lie overwhelmingly on the right hand side:  more than 90 percent of developing countries show positive correlations (procyclical spending).  Black bars dominate the left hand side:  around 80 per cent of industrial countries show negative correlations (countercyclical spending).

Over the last decade there has been a historic shift in the cyclical behavior of fiscal policy in the developing world.     Figure II updates the statistics, showing the period 2000-2009.  The number of yellow bars on the left side of the graph (negative correlations) has greatly increased.   Around 35 percent of developing countries [26 out of 73] now show a countercyclical fiscal policy, more than quadruple the share during the earlier period.

Figure II

[Click here for enlargement of Figure II.] 

Figure III presents a scatter plot with the 1960-1999 correlation on the horizontal axis and the 2000-2009 correlation on the vertical axis.  The lower right quadrant shows the graduates from procyclical to countercyclical fiscal policy.  The star performers include Chile and Botswana; but 24 developing countries altogether (out of 73) have made this historic shift.


[Click here for enlargement of Figure III.] 

The evidence of countercyclicality among many emerging market and developing countries matches up with other criteria for judging maturity in the conduct of fiscal policy:    debt/GDP ratios, rankings by rating agencies, and sovereign spreads.  Low income and emerging market countries in the aggregate have achieved debt/GDP levels around 40 percent of GDP over the last four years.  [The IMF estimates the 2011 ratio at 43 per cent among emerging market countries and 35 per cent among low-income countries]. This is the same period during which debt in advanced countries has risen from about 70 per cent of GDP to 102 percent.   The financial markets have ratified the historic turnaround.   Spreads are now lower for many emerging markets than for some “advanced countries.”    Rating agencies rank Singapore as more creditworthy than Belgium, Korea ahead of Portugal, Mexico ahead of Iceland, and just about everybody ahead of Greece.    Euromoney ranks Chile as less risky than Japan, Korea less risky than Italy, Malaysia less risky than Spain, and Brazil less risky than Portugal.

Largely as a result of their improved fiscal situations during the period 2000-2007, many emerging markets were able to bounce back from the 2008-2009 global financial crisis more quickly than advanced countries.

What explains the ability of some countries, particularly emerging market and developing countries, to escape the trap of procyclical fiscal policy? Many researchers have pointed to the importance of institutions.  In new research we find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality (which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment).    The relationship holds also when instrumental variables are used.

Although one thinks of institutions as slow-moving, they can change over time.   Chile’s institutional quality has risen strongly since the early 1980s, during which time its fiscal policy has turned from procyclical to countercyclical.   A country with good institutional quality in the general sense of rule of law can help lock in countercyclical fiscal policy through specific budget institutions.   Chile did it with the structural budget reforms of 2000 and 2006.   Chile’s approach could be emulated by others.

Fiscal rules, such as euroland’s  Stability and Growth Pact, may accomplish little in themselves.   Rules can actually worsen the tendency of governments to make overly optimistic forecasts for economic growth and budget balance.   Chile’s key innovation was to give responsibility for forecasting to independent expert commissions, insulated from politicians’ wishful thinking.

Even advanced countries have something to learn about countercyclical fiscal policy from Chile and others to the South.  Saving during expansions such as 2001-06 is critical for weathering the storm in recessions such as 2008-09.  Otherwise there may be no way out but to adjust at the worst possible time.

The Federal Government Races to the Cliff

In the 1955 movie Rebel Without a Cause, James Dean and a teenage rival race two cars to the edge of a cliff in a game of chicken.  Both intend to jump out at the last moment.  But the other guy miscalculates, and goes over the cliff with the car.

This is the game that is being played out in Washington this month over the debt ceiling.  The chance is at least 1/4 that the result will be similarly disastrous.    

It is amazing that the financial markets continue to view the standoff with equanimity.   Interest rates on US treasury bonds remain very low, 3% at the ten-year maturity.   Evidently it is still considered a sign of sophistication to say “This is just politics as usual.  They will come to an agreement in the end.”  Probably they will.  But maybe not.   (I’d put a ½ probability on an agreement that raises the debt limit, but just muddles through in terms of the genuine long term fiscal problem.  That leaves at most a ¼ probability of a genuine long-term solution of the sort that President Obama apparently proposed last week – described as worth $4 trillion over ten years.)

My advice to investors is to shift immediately out of US treasuries and into high-rated corporate bonds.  If the worst happens, you will probably save yourself from a big capital loss within the next month.  If not, there is no harm done.

The game is not symmetric.  The Republicans are the ones who are miscalculating.   Evidently they are confident of prevailing:  they rejected the President’s offer, even though he was willing to cut entitlement programs.

The situation is complicated because there are a number of different people crammed into the Republican car.    There is one guy who is obsessed with the theory that, come August 3, the federal government could retain its top credit rating if it continued to service its debt by ceasing payment on its other bills.  But this would mean failing to honor legal obligations that have already been incurred (paying suppliers for paper clips that have already been bought, paying soldiers their wages for last month’s service, sending social security recipients their checks, etc.).  This is like observing that the cliff is not a 90 degree drop-off, but only 110 degrees.   It doesn’t matter: the car would still go crashing into the ocean far below.   The government’s credit would still be downgraded and global investors would still demand higher interest rates to hold US treasuries, probably on a long-term basis. 

There are other guys (and gals) in the car who are even more delusional.   They are dead set on a policy of immediately eliminating the budget deficit (e.g., those opposed to raising the debt ceiling no matter what, or those campaigning for a balanced budget amendment), and doing it primarily by cutting nondefense discretionary spending.  This is literally impossible, arithmetically.  But they honestly don’t know this.   It is as if they were insisting that the car can fly.   Sometimes it can be a good bargaining position to adopt a very extreme position.  But if you are demanding that the car flies, you are not going to get your way no matter how determined you are. 

It seems likely that the man in the driver’s seat – House Speaker John Boehner – does realize that his fellow passengers don’t have the facts quite right.   But there is also a game of chicken going on within the Republican car.  The crazies have said they will oppose in the next Republican primary election any congressman who votes to raise the debt ceiling or to raise tax revenues.   (Yes, they think they would support someone who would eliminate the budget deficit primarily by cutting non-defense discretionary spending; but remember, this is arithmetically impossible.)   The guy who is riding shot-gun in the car – the one who believes the car can fly — is trying to put his foot on top of Boehner’s on the accelerator pedal.   

It seems to me that Boehner, too, is miscalculating.  Given that the car can’t fly, the crazy guy is probably going to oppose him in the primaries no matter what he does.   So I don’t see what his plan is.   But whatever it is, he has made it clear that he doesn’t plan to agree to any increase in tax revenues.   

As a result the Republican leadership is in the remarkable situation of refusing to agree to Obama’s offer to solve the problem so long as the solution includes raising tax revenue, even if it is via such measures as ending distortionary subsidies for ethanol, oil companies, and corporate jets.

If I had to guess:   The financial markets will wake up just before August 3.   US bond prices will finally fall.  The market reaction will shock the Republican leadership into action.  (Precedents include the delayed congressional passage of the unpopular TARP legislation in the fall of 2008 and the delayed passage of an unpopular IMF quota increase 10 years earlier.)   They will finally make the small but necessary concessions on tax revenues.   But by then it might be too late.