What Small Countries
Can Teach the World
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth,
Harvard University
& Director of Program in International Finance & Macroeconomics,
National Bureau of Economic Research
NBER Session, NABE Annual Meeting, Dallas, September 11, 2011
Countries need a model
• In the past, countries
choosing social systems,
development strategies, or
specific institutions usually
looked to the big powers
for inspiration
• Europe,
• USSR,
• Japan,
• US.
Project Syndicate , Oct.2010.
2
• Two decades ago, many thought
the lesson of the 1980s had been that Japan’s
variant of capitalism was the best model:
– Including such institutions as:
• Strategic trade policy,
• relationship banking,
• life-time employment…
– Other countries should follow it.
• The Japanese model
quickly lost its luster in the 1990s.
3
• One decade ago, many thought
that the lesson of the 1990s had been that
the US variant of capitalism was the best model –
– Including American-style corporate governance:
• Securities markets,
• accounting standards,
• compensation for CEOs (options…)
– Other countries should follow.
• The American model in turn
lost its attractiveness in the decade of the 2000s.
4
To whom should countries around
the world look for inspiration, now?
European Financial Review, 2011.
5
Meanwhile, many smaller countries
on the periphery have experimented
with policies and institutions that
could usefully be adopted by others.
European Financial Review, 2011.
Institutions worth emulating.
6
• Countries that are small, newly independent,
far-away, or emerging from a devastating war,
are often more free to experiment,
– than is the US or other large established countries.
• Not all the experiments will succeed.
• But some will.
• The results may include useful lessons.
7
Some micro examples
• Costa Rica in Central America
and Mauritius in Africa
each pulled ahead of its
regional peers long ago.
• Among other decisions that worked out well for
them, both countries have foregone a standing army.
– The result in both cases: no-coup histories;
– and financial savings that were used for good things,
• such as education and investment.
8
• Singapore achieved rich country status
with a unique development strategy.
• Among its many innovations were:
– a paternalistic approach to saving; and
– congestion pricing
for auto traffic.
9
The price mechanism to
address traffic congestion
• has been emulated by London since 2003.
• More cities
should follow.
10
CCT programs
• Mexico pioneered Conditional Cash Transfers
(the OPORTUNIDADES program —
originally called PROGRESA, launched in 1998).
• CCT programs have subsequently
been emulated by many developing countries.
– Notably Lula’s Bolsa Familia in Brazil.
• Two revolutions in one:
– (1) the specific idea of making poverty transfers contingent on
child school attendance (which has been emulated even in NYC)
– (2) the methodological idea of conducting controlled experiments
to find out what policies work or don’t work,
• which fed into the exciting Randomized Control Trials movement.
11
Some small advanced countries
also have lessons to offer.
• New Zealand led the way
with Inflation Targeting,
– along with many late-1980s liberalization reforms.
– Its Labor Party could even be given credit for
pioneering the principle that some left-of-center
governments can achieve economic liberalization
better than their right-of-center opponents.
12
• Ireland stressed
Foreign Direct Investment.
• Estonia led the way in
simplifying its tax system
by means of a successful flat tax in 1994,
• followed by Slovakia
• and other small countries in Central/Eastern Europe.
13
• In highlighting some very specific institutions that
could be usefully applied elsewhere, I don’t mean
to suggest that they can be effortlessly translated
from one national context to another.
• Nor do I mean to suggest that these examples
are entirely responsible for the success
of the economies identified.
– Indeed a few of these countries
have recently been wrestling with severe problems.
• But a country doesn’t have to be large like
the U.S. to serve as a model for others.
14
My most important example:
Chile’s fiscal institutions
• Most developing countries in the past
suffered from procyclical fiscal policy:
– In boom times they would increase spending,
– in downturns they were forced to cut back;
– thereby exacerbating the business cycle.
• Kaminsky, Reinhart & Vegh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini (2008),
Mendoza & Oviedo (2006), Ilzetski & Vegh (2008) and Medas & Zakharova (2009).
– Especially Latin American commodity-exporters.
• Gavin & Perotti (1997), Calderón & Schmidt-Hebbel (2003) and Perry (2003).
• The correlation of govt. spending & GDP > 0;
– almost 1 for Oman, for example.
15
Correlations between Government spending & GDP
1960-2002
procyclical
Kaminsky, Reinhart & Vegh (2004)
countercyclical
G always used to be pro-cyclical
for most developing countries.
16
Historic role reversal
• Since 2000, one third of the EM/developing countries
have “graduated” from procyclical fiscal policy
to countercyclical,
– running primary surpluses ,
providing for future pension costs, &
cutting debt during the 2002-07 boom.
– By 2007, Latin America had cut its debt to 33% of GDP,
• as compared to 63 % in the United States.
– allowing easing in the 2008-09 global recession.
17
Correlations between Government spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2011)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
18
• Debt levels in top 20 emerging markets are now
< half those in rich countries (debt/GDP ratios ≈ 80%) .
• Some emerging markets have earned credit ratings
higher than some so-called advanced countries.
• During the same period when these countries
learned how to run countercyclical policy,
it seems that the US and Europe forgot how.
– They allowed large deficits during the expansion,
– and now feel constrained to cut spending, despite depressed GDP.
• How did they do it?
19
Chile in 2000
instituted a structural budget rule
• The institution was formalized in law in 2006.
• The rule: the government must set a target
for the structural budget deficit,
– which President Bachelet set at 0,
• where “structural” is defined as output & copper price
equal to their long-run trend values.
• I.e., in a boom the government
can only spend increased revenues
that are deemed permanent;
any temporary copper bonanzas
must be saved.
20
• Chile’s fiscal position strengthened immediately.
– allowing national saving to rise from 21% to 24% by 2005.
• Government debt fell sharply as a share of GDP
and the sovereign spread gradually declined.
• By 2006, Chile achieved a sovereign debt rating of A,
• By 2007, Chile had become a net creditor.
• By 2010, its sovereign rating had climbed to A+,
– ahead of some advanced countries:
– Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).
21
• In 2007-08, with copper prices spiking upward,
the Bachelet government was under
intense pressure to spend the revenue.
– She & Fin.Min.Velasco held to the rule, saving most of it.
– Their popularity ratings fell sharply.
• When the 2009 recession hit and the copper price
came back down,
the government
raised spending,
mitigating
the downturn.
– The Ministers’ popularity
reached historic highs
in 2009.
22
• A budget target of zero may sound familiar
– like the budget deficit ceilings that supposedly constrain
members of euroland
(deficits < 3 % of GDP under
the Stability & Growth Pact)
– or like the U.S. proposals
for a Balanced Budget Amendment (deficit = 0).
• But those attempts fail. Two reasons:
– (1) They are too rigid to allow the need for deficits
in recessions, counterbalanced by surpluses in good times.
• and lack credibility from the beginning.
– But even structural budget rules fail.
– Why? My hypothesis:
– (2) Politicians make overly optimistic forecasts
of growth & budgets,
• thus avoiding cutbacks.
23
Official budget forecasts are biased toward optimism
especially if GDP is currently high & especially at longer horizons
Budget balance forecast error
as % of GDP, Full dataset
(1)
(2)
(3)
33 countries
One year ahead
Two years ahead
Three years
ahead
GDP relative
to trend
0.093***
0.258***
0.289***
(0.019)
(0.040)
(0.063)
0.201
0.649***
1.364***
(0.197)
(0.231)
(0.348)
Constant
Observations
398 up with the year 300
Variable is lagged so that it lines
in which the forecast 179
was made.
*** p<0.01, ** p<0.05, * p<0.1
Robust standard errors in parentheses, clustered by country. 24
Official budget forecasts are more biased toward optimism
in countries subject to a budget deficit rule (SGP)
Budget balance forecast error
33 countries
SGPdummy
as a % of GDP, Full Dataset
(1)
(2)
(3)
(4)
One year
ahead
Two years
ahead
One year
ahead
Two years
ahead
0.658
0.905**
0.407
0.276
(0.398)
(0.406)
(0.355)
(0.438)
0.189**
0.497***
(0.0828)
(0.107)
SGP dummy *
(GDP - trend)
Constant
Observations
0.0330
0.466*
0.0330
0.466*
(0.228)
(0.248)
(0.229)
(0.249)
399
300
398
300
*** p<0.01, ** p<0.05, * p<0.1
Robust standard errors in parentheses, clustered by country. 25
The crucial institutional innovation in Chile
• Chile has avoided over-optimistic official forecasts,
– especially the historic pattern of
over-exuberance in commodity booms.
– How?
• The estimation of the long-term path
for GDP & the copper price
-- and so how much of a copper bonanza can be spent --
is made by two panels of independent experts,
– and thus is insulated from political pressure & wishful thinking.
• Other countries could usefully emulate Chile’s innovation
– or in other ways delegate to independent agencies
estimation of structural budget deficit paths.
26
European Financial Review, 2011.
27
Appendix:
US fiscal policy
since 2001
28
The US public debate is framed as a battle between
conservatives who philosophically believe in strong
budgets & small government, and liberals who do not.
Not the right way to characterize the question.
• The right goal is budgets that allow
surpluses in booms and deficits in recession.
•
The correlation between how loudly an American politician proclaims a belief in fiscal conservatism and how likely he is to take corresponding policy steps < 0.
29
US fiscal policy 2001-08
• The U.S. is an example of those overly optimistic
government budget forecasts.
• When the Bush administration took office in January 2001,
it forecast $5 trillion in cumulative budget surpluses for the decade.
• Its over-optimism took three forms:
– 1) Overly optimistic economic/technical assumptions
• E.g., not allowing for a possible future recession.
– 2) Faulty economic theories regarding tax cuts:
• the “Laffer Hypothesis” and “Starve the Beast”
– 3) Tricks to force CBO to score the base budget
• E.g., phony sun-setting of tax cuts in 2010, 2012
• Pretending each year that the wars in Iraq & Afghanistan would end.
30
Budget forecasts by the Bush White House
then had to be revised down every year
400
300
200
US$ bn
100
0
-100
-200
-300
-400
-500
Jan.
2001
Source: OMB
Aug.
2001
Jan.
2002
2002
Aug.
2002
Jan.
2003
2003
2004
Aug.
2003
Jan.
2004
31
US fiscal policy over the past decade,
continued
• The forecasted surpluses helped Bush launch
a 10-year path of un-conservative fiscal policy:
– tax cuts
– & accelerated spending
• > twice Clinton’s rate of spending growth.
• The results:
– a cumulative $5 trillion in decade budget deficits.
– Today, in 2011, although the economy is weak,
Washington feels constrained by its debt
to withdraw fiscal stimulus.
32
Faulty tax cut theory I -- Laffer Hypothesis:
“Tax cuts stimulate activity enough to raise revenue”
Statistical
evidence
against it
Explicit disavowal
by presidential
economic advisers
Did these Administrations,
then, never actually claim
the Laffer Proposition?
Goolsbee (1998,
1999, 2000), Kasten,
Weiner & Woodward
(1999); Burman &
Randolph (1994),
Auerbach & Siegel
(2000).
Reagan’s advisers:
Pres. Reagan 7/7/81 :
Martin Feldstein (1985):
“…our kind of tax cut will so stimulate the
economy that we will actually increase
government revenues.”
Feldstein (1994).
Treas.Sec. Don Regan (1988)
Gale & Potter
(2002), Gale &
Kotlikoff (2004);
Uhlig & Trabandt
(2006), Heijman &
van Ophem (2005)
Bush’s advisers:
Pres. GWB
“Each of those predictions has
proven to be wrong.”
Greg Mankiw (1998):
11/13/2002,
7/24/03, 8/6/05, 8/22/06, 7/11/06;
“…history failed to confirm VP Cheney 1/30/03, 2/9/06;
Laffer’s conjecture …”
Sec.Snow 2/7/06; Press Sec.Fleischer 1/8/03;
Glenn Hubbard (2003).
OMB Dir. Bolten 7/03, 12/10/03, 7/05.
33
Faulty tax cut theory II –
The Starve the Beast Hypothesis:
“Tax cuts lower revenue which forces spending cuts.”
Statistical evidence against the Hypothesis
William Niskanen (2002);
-- (2004) “Starve the Beast Does Not Work,” Cato Policy Report 26, March;
-- (2006), “Limiting Government: The Failure of ‘Starve the Beast’,”
Cato Journal, Fall.
Gale & Orszag (2004), "Bush Administration Tax Policy: Revenue and
Budget Effects," Tax Analysts
Romer & Romer (2007) “Do Tax Cuts Starve the Beast: The Effect of
Tax Changes on Government Spending,” NBER WP no. 13548
34
“Starve the Beast” does not work: Tax cuts were
not associated with spending cuts. To the contrary.
Vs. the 1990s: The Shared Sacrifice approach succeeded in
eliminating budget deficits, importantly by slowing spending.
Spending and Budget Balance(inverse) as % of GDP (Current US$)
|Tax cut regime || Tcr |Shared sacrifice regime | Tax cut regime |
15
24
13
22
11
20
9
18
7
ρ = 0.86
5
16
G.W. Bush
R. Reagan
G.H.W. Bush
10
1
-1
-3
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008 Est
2009 Est
2010 Est
12
J. Carter
14
W.J. Clinton
3
Spending/GDP
Budget Balance/GDP
Source:
35
OMB
This talk draws on the following writings
• Some Big Ideas from Small Countries, European Financial Review, May 2011.
• "Big Ideas from Small Countries,“ in Project Syndicate , Oct.2010. Blog .
• "Mauritius: African Success Story," forthcoming, S.Edwards, S.Johnson, & D.Weil,
eds. NBER WP 16569, Dec.2010.
•
"Over-optimism in Forecasts by Official Budget Agencies and Its
Implications," forthcoming, Oxford Review of Economic Policy, 2011. NBER WP 17239.
• “A Solution to Fiscal Procyclicality: The Structural Budget Institutions
Pioneered by Chile,” forthcoming, Fiscal Policy and Macroeconomic Performance,
Series on Central Banking Analysis, & Economic Policies , Nov. 2011. NBER WP 16945.
• A Lesson from the South for Fiscal Policy in the US & Other
Advanced Countries," Comparative Economic Studies, Sept. 2011.
• “On Graduation from Procyclicality,”with C.Végh & G.Vuletin, Aug.2011. VoxEU.
•
“Snake-Oil Tax Cuts,” EPI Briefing Paper 221, 2008.
36