A solution to fiscal procyclicality

de Jeffrey A. Frankel

"Historically, many countries have suffered a pattern of procyclical fiscal policy: spending too much in booms and then forced to cut back in recessions. This problem has especially plagued Latin American commodity exporters. Since 2000, fiscal policy in Chile has been governed by a structural budget rule that has succeeded in implementing countercyclical fiscal policy. Official estimates of trend output and the 10-year price of copper - which are key to the decomposition of the budget into structural versus cyclical components - are made by expert panels and thus insulated from the political process. Chile's fiscal institutions hold useful lessons everywhere, but especially in other commodity exporting countries. This paper finds statistical support for a series of hypotheses regarding forecasts by official agencies that have responsibility for formulating the budget. 1)Official forecasts of budgets and GDP in a 33-country sample are overly optimistic on average.2)The bias is stronger at longer horizons3)The bias is greater among European governments that are politically subject to the budget rules in the Stability and Growth Pact (SGP).4)The bias is greater in booms.5)In most countries, the real growth rate is the key macroeconomic input for budget forecasting. In Chile it is the price of copper.6)Real copper prices mean-revert in the long run, but this is not readily perceived.7)Chile has avoided the problem of overly optimistic official forecasts.The conclusion: official forecasts tend to be overly optimistic, if not insulated from politics, and the problem can be worse when the government is formally subject to budget rules. The key innovation that has allowed Chile to achieve countercyclical fiscal policy in general, and to run surpluses in booms in particular, is not just a structural budget rule in itself, but a regime that entrusts to independent expert panels responsibility for estimating long-run trends in copper prices and GDP"--National Bureau of Economic Research web site.