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:
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.
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.
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).
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.
