Stabilizing Role of Fiscal Policy
Roberto Rigobon
MIT
November 2011
What are the tools for
stabilization?
• Which ones are the typical responses?
– Monetary Policy
• Interest rates and money supply
• Reserve requirements
– Exchange rate policy
• Interventions
• Capital controls
• What is never answered?
– Fiscal Policy
Response to capital inflows?
• Indeed, fiscal policy is perhaps the best
tool to deal with capital inflows
– Monetary policy creates a reinforcing loop
– Capital controls creates other inefficiencies.
– Fiscal policy creates a balancing loop and
reduces the distortions.
But fiscal policy is
almost never stabilizing…
• In general fiscal policy is pro-cyclical and
therefore it is rarely stabilizing. It is
destabilizing.
– Revenues are volatile
– Savings are difficult
What is the revenue problem?
• Fiscal revenues are extremely volatile in several
emerging markets
– Different sources of risk:
• Commodity prices (exports)
– This is perhaps the most important source of risk in Latin America and
Africa.
• Recessions
– Political, financial, and social crises are an important source of fiscal
risk.
• Natural Disasters
– El Niño, Hurricanes, Earthquakes, etc.
What are the implications?
• Procyclicality of fiscal policy
– Cost?
• Excessive cycles
• Excessive volatility of the real exchange rate
– Why?
• Lack of insurance
• Underdeveloped financial sector
• Political economy
Procyclical Fiscal Policy
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Volatility of the long run real exchange rate
Developing countries
3
What are the Implications?
• Exchange rate volatility and pro-cyclical
fiscal policy put pressure on
•
•
•
•
•
Monetary policy
Banking sector
Investment (if irreversible)
High interest rates (if risk aversion)
Inefficient specialization
Costs to the Economy
• High real exchange rate volatility is
associated with lower investment and
growth, weaker banking sector, inefficient
specialization, and dolarized economy.
• Pro-cyclical fiscal policy is associated with
lower growth, higher frequency of
exchange rate crises, higher real interest
rates, and less efficient tax systems.
What can be done?
• Classical view
– Insure the risk.
•
•
•
•
Transfer the risk to foreigners
Future markets
Contingent debt
Stabilization Fund
What can be done?
• Insure the risk.
– Transfer the risk to foreigners
• What to do?
– Sell the risky sector:
» Commodity producing sector.
• How it works?
– Sell the sector to foreigners and then they bear the risk
– The country consumes the annuity of the privatized proceeds
• Problems:
– Who will purchase natural disaster risk?
– Credibility and privatization price.
What can be done?
• Insure the risk.
– Future markets
• What to do?
– Stabilize price fluctuations in future markets
• How it works?
– The country agrees on a price for exports in the future.
– If the spot price is above the agreed price, the country
experiences a loss in the financial asset. The opposite if the
spot price is below.
– Notice that the returns on the financial instrument are
negatively correlated with the spot price change.
• Problems:
– Volumes cannot be stabilized
– Future markets are sometimes illiquid
– Futures for long run horizons are extremely illiquid
What can be done?
• Insure the risk.
– Contingent Debt
• What to do?
– Interest rates indexed to commodity prices or natural disasters
• How it works?
– The interest rate is indexed to the risk.
– A negative shock implies a reduction in interest payments. The
opposite if there is a positive shock.
– Notice that the interest rate payments are negatively correlated
with the risk source.
• Problems:
– Partial insurance at best.
– Very costly – the country has to have enough debt.
– Market does not seem to like this instruments
What can be done?
• Insure the risk.
– Stabilization Fund
• What to do?
– Self-insurance: Save in good times and withdraw in bad times.
• How it works?
– Use savings to stabilize resources in bad times. The opposite in
good times.
– The returns on the savings should be negatively correlated with
the risk factor
• Problems:
– Partial insurance at best.
– Very costly – the country has to save.
– Important problems of design.
What happens in practice?
• Risky sectors are rarely sold
• Future markets are extremely limited.
– Specially in commodity markets.
– Good and liquid in the short run, but not in the long
run
• Contingent debt
– Experiences have been very negative
– Even in cases of hurricanes where moral hazard does
not exist
• Most countries end up implementing a
Stabilization Fund.
Stabilization Funds
• What is the experience in the world?
– Horrible
– Really Horrible
– Appropriability:
• Most stabilization laws are changed frequently.
– Specially when the resources saved are too large
– Defeating their stabilization purpose.
– Governability:
• Most stabilization funds are associated to one risk source instead of overall
fund.
• This includes:
– The asymmetric debt financing
– The saving versus expenditure rule
– Stochastic process:
• This determines the expenditure rule. Hence, the proper estimation is
crucial.
Stabilization Funds
• Appropriability
– When the resources are too large, the political temptation to
change the law and withdraw more resources is too big.
• Governability
– Stabilization funds should stabilize government revenues, and
not the flows of each source of risk
• Stochastic Process
– Estimation of the stochastic process is rarely part of the design.
Most stabilization funds just use moving averages as rules and
become saving rules instead of expenditure rules.
Appropriability
• What can be done?
– Invest resources better
• Most funds invest resources in US Treasury Bonds. Why?
• Wouldn’t be better to invest in assets that are negatively
correlated with the source of risk?
– Cap on funds
• Recognize that there is a political economy problem and limit
the resources accumulated ex-ante
– Implies that full stabilization is impossible
– Have discussion on how the non-saved funds are going to be
spent.
Governability
• What can be done?
– Have one stabilization fund for all fiscal
revenues, independently of all the sources of
risk.
– Delegate key parameters in the expenditure
rule to an independent institution.
• The “discussion” process is more important than
the rule itself.
• Chilean case
Lessons
• Fiscal risk can be very damaging to investment and growth.
– Pro-cyclicality of fiscal policy.
– Real exchange rate volatility.
• Most stabilization responses are not available.
– Therefore, stabilization funds are the preferred policy.
• Most stabilization funds have been incorrectly desgined
– Appropriability.
– Governability.
– Stochastic process.
• Key insights about design
–
–
–
–
Better investment policies.
Cap on the funds.
One fund for aggregate fiscal revenues.
Independent fiscal council to determine key variables in the rule (buy in)