Notes on Lessons from Chile

I attended this morning's Grattan Lecture on the Chilean Fiscal Framework, delivered by Dr. Andrés Velasco. The lecture started at 8:30 in the morning and they weren't kidding, so I missed the first half hour.

Chile has privatised pensions, but there is a public safety net to supplement very low pension payments. This means there is no "pay as you go" dynamic [usually referred to here as the "pensions time bomb"].

In what Chile calls the Structural Balance Approach, a fiscal council constructs a long-term model for the economy that can be used to predict future GDP growth trends. The council examines trends in basic economic drivers (such as the price of copper) to come up with that model. They then apply cyclical adjustment methodology close to the OECD procedure.

The council needs to be independent of the political government.

The council is divided into groups: one group produces estimates of copper futures, another group does GDP growth. The output of each group goes into "the blender" to produce estimates of state revenues.

X% of GDP is subtracted as a safety buffer. X was 1 initially, but then government debt hit zero and the government was still accumulating assets, so X was revised to 0.

In 2001, the government adopted this arrangement as policy without any legal obligation. In 2006, the Fiscal Responsibility Law gave a statutory basis to it, but it didn't nail down the predictive methodology or the economic targets used.

Initially, copper prices were low and so the council recommended deficits, which were warmly welcomed by the politicians. But soon copper prices rose and the fiscal council started demanding surpluses (i.e. spending cuts), which wasn't so popular at all.

The Fiscal Responsibility Law said that surplus funds must be divided as follows:

  • Between 0.2% and 0.5% of GDP goes into pension reserves;
  • 0.5% of GDP goes into recapitalising the Central Bank; and
  • The rest goes into the Stabilisation Fund (explained later).

It's important to prepare the politicians and the public for the large surpluses that this scheme can produce. They reached 8% of GDP in Chile and they threatened to go higher. The Minister for Finance (Dr. Velasco) was "the most widely hated person in the country". Effigies of him were frequently burned. He often appeared on morning TV, taking 30-second slots between the aerobics and the cookery, to explain it. He learned to explain it like this: "We're doing what you do at home: saving money aside for a rainy day." The operation of the Fiscal Responsibility Law was "very controversial stuff".

The 2009 budget followed the crash, and it turned an 8% surplus into a 4% deficit. However, the 2009 budget was successful at turning the economy around. The 2010 budget was balanced.

Chile's net public debt was 40% of GDP in 1991. By 2006 it had been reduced to zero.

The government must be willing to live with the political pressure to increase spending during the boom years. The Stabilization Fund reached its maximum size (US$20 billion, or 11% of GDP) in January 2009. Dealing with the crisis involved drawing US$8 billion from the fund.

Chile's output stability (roughly the standard deviation of the economic output, reckoned over a reference period of about a decade) fell dramatically over the years. Chile's ability to cushion changes in the "real exchange rate" [something to do with trade imbalances, I think] was the subject of a graph. The real exchange rate was a damped oscillation, converging on its long-term average.

The January 2009 stimulus package amounted to 2.8% of GDP and it consisted of infrastructure investment, extra support for poorer households, and temporary tax cuts.

An odd scatterplot rated several countries on two axes: the size of their interest rate adjustments versus the size (in US$) of their fiscal stimulus packages. Most countries were bunched together in the low-size area, and a few countries with small fiscal adjustments had high interest rate adjustments, but Chile was the only country on the graph with both a high fiscal response and a high monetary response. [I suppose this indicates that Chile's Stabilization Fund gave it the freedom to deal with the crisis by virtue of having more than enough resources on standby.]

To make the rules optimal, there are four main questions:

  1. What to correct for?

    Chile's two criteria were GDP growth and copper. Dr. Velasco would have liked to include the real exchange rate and the stock of government assets, but they were excluded in order to keep the criteria simple to understand. "You want the rule to be something a taxi driver can understand." Also excluded were: expenditure-led activity, sectoral booms, and movements in asset prices. Essentially, you should distinguish permanent from temporary income. For Ireland, you should also exclude revenue driven by the cycle, such as VAT returns.

  2. Cyclical adjustments should be getting you close to Milton Friedman's Permanent Income Hypothesis (PIH).

    There were big fights over how the adjustments' effects should be accounted for in the fiscal rules. The adjustments must be temporary. Chile's law dictated that the stimulus tax cuts must be temporary. Otherwise there would have been huge pressure to keep the tax low after the crisis was over.

  3. Degree of counter-cyclicality

    Engel, Neilson and Valdés (2010) studied this. You need a "switching regime" to decide when to switch from the counter-boom strategy to the counter-bust strategy and vice versa. The challenges here are simplicity (the taxi-driver standard) and legitimacy (meaning free from political interference).

  4. Ex ante versus ex post conflict

    Fiscal targets (Ex ante) are never going to exactly match the actual outcomes (ex post). There are too many significant variables to be able to predict things exactly. It's necessary to fudge the predictions just like central banks do with inflation figures. That is, specify a range of values for the target, and a range of time in which the target can be met. Alternatively, you can let a (non-political) fiscal council decide to activate an escape clause in order to meet unexpected external crises.

Finally, he offered two caveats about the whole approach. Legislating it is not enough; it must be seen as politically legitimate. There are a lot of variables in how to do it, and we could really use experience from trying the approach in more countries.

In answer to questions from the floor, he pointed out that he was appointed to the Minister for Finance position from outside the electoral system (it's a presidential system), so he didn't have to face angry voters on election day. He also said that the biggest fight was in September 2006 when the proposed budget contained a surplus of 5%.

So there we go. This was a very interesting lecture on its own merits, but I was struck by one thing. Here was a politician from a far-away, non-English-speaking country who didn't have to collect popular votes to be elected; and he was far more eloquent, more relaxed and more organised in his address than any of the 165 recently-elected TDs.

3D Secure coming to Bank of Ireland credit cards

My credit card statement warned me today that

3D Secure is launching at the end of March. This free, automatic online security service will make spending online safer than ever!

The promotional insert contained more reassuring messages:

  • as secure as possible
  • verify your identity by answering four questions [name, CVV2, date of birth and mother's maiden name]
  • we will also display your personal greeting giving you added comfort that it is Bank of Ireland who are asking you to enter your 3D Secure Password

Of course, from Murdoch and Anderson's paper we know that 3D Secure is worse than ineffective. So I have questions for Bank of Ireland:

  1. Do the terms and conditions move the burden of losses by fraud onto the cardholder?
  2. Is the Access Control Server outsourced? If so, to whom? What are their practical incentives to maintain high security standards?
  3. What is the official policy on selecting a CA for the ACS SSL certificate? If there isn't one, how can cardholders protect themselves against compelled certificate creation attacks?
  4. What will happen if a fraudster with my card details uses the forgot password procedure in an attempt to negate the benefit of 3D Secure? Will I still be stuck with the cost of the fraud?
  5. Can I be authenticated by something better than a password, for example a DDA card reader?
  6. Can I get an automatic notification every time there is an authentication attempt on my card number?

I couldn't find any information about this on www.bankofireland.com, so I'll phone them tomorrow and post the result. I'm sure it will be comforting.