The un-Whining road of Fiscal Policy

Nouriel in his response to my “Worried, Whining, and un-Willing” blog asks several interesting questions. First, how fiscal policy can help with real exchange rate appreciation in general, and with capital inflows in particular? Second, can this be used elsewhere, such as in Brazil and Argentina? Third, what are the implications to the political economy of fiscal surpluses? And finally, can the improvement in the fiscal accounts backfire and actually push capital inflows even further?

If this were a social party in Boston, and someone approaching me would have asked these questions, I would have been tempted just to answer “it depends”. Then, after some pause, I would continue sipping on my drink, in silence (of course) and with a “deep thoughtful” look. Mainly, with the hope that the person asking thinks “WOW!, This is so complex and profound that I do not even deserve an answer. What should I do? Let’s talk about the Red Sox, or Randy Moss, or anything that starts with R.”

However, I’m not in a party, although it is not clear that I am not drinking… (coffee, I mean).

Fiscal policy helps resolve the problem of real exchange rate appreciation in two ways: First, as Nouriel points out, the standard channel is that it reduces aggregate demand, lessening the pressure on non-tradables – such as housing – and ultimately helping the exchange rate. The second channel is that the tax can be levied on the asset that is suffering the “bubble”. In the case of Colombia, the housing market is booming, and I can perfectly imagine that a 30 percent taxes on capital gains in real estate would do marvelous things to reduce the construction in Bogota. Actually, 30 is just an example, O.K.? I know it might be too much, so, no hate mail please. A sizeable proportion of the “hot money” that enters Latin America goes to the non-tradable sector because investors know this is a one sided bet. The central bank either causes more inflation or accepts the appreciation. Investors know the first one is more important (as it should be), and therefore flows will continue coming. To stop them, there has to exist the expectation that profits in the non tradable sector are smaller – either because we tax them, or because the exchange rate does not appreciate as much as a consequence of the fiscal policy actions.

The second point refers to applying the same policy to other countries. This is a great point, and it is not clear that this advice should be followed by every country on earth – maybe only those that play soccer. To me, Argentina and Brazil, as well as South Africa for that matter (although this one belong to a different blog), are in the exact same situation as Colombia is. There is an improvement in the terms of trade that is accompanied by a massive inflow and excessive consumption. In fact, a terms of trade improvement is a “supply” shock which is when inflation targeting performs the worst. In this environment the central bank is in a corridor in which the options are very limited: hell 1 or hell 2 – i.e. inflation or appreciation. On the other hand, imagine if the commodity boom would have been saved in dollars in the US (by the private sector or the fiscal authority) as opposed to being spent in the domestic economy, the appreciation would have been less, the inflows financing additional consumption would have been smaller, and the central bank would have been able to actually control the economy much easier. I think fiscal policy not only can, but should, achieve such saving. We are asking the Central Bank to do the saving, and they are just limited to do so. The third point is also a very good one. And I do not have a very good answer to that one. It is absolutely correct that our governments are short sighted and if massive savings are allocated in the name of “macro-stabilization”, it is unclear that politicians are going to avoid the pressures to misuse them – which in the end defeat the whole purpose of having saved them. I know this is the case in Latin America. Having help several countries design “stabilization funds”, and see the policies being reversed a couple of years later, I have learned the lesson, and I have become skeptic of the possibility that fiscal responsibility will ever exit in some of our countries. However, the fact that I believe it has a small chance of happening does not mean that I should not say that they are missing on a great opportunity to do the right policy at the right time. So, I agree with Nouriel that in some countries this is impossible, and with the push toward the left that my beloved president (Chavez) is leading, saving resources at this time might prove much harder for all as well. In fact, maybe my “un-Willing” part should also include this possibility.

Finally, can the fiscal improvement backfire? Another great question! I know, it might sound as if I’m sucking-up, but I’m not. In fact, someone that I do not know (Paulo F. Hermanny) asks exactly the same question and I think his one is as good. So, there you go, they are truly good questions. The intuition is as follows: if there are doubts about the fiscal sustainability of Brazil or Colombia, then an increase in taxes reduces the probability of bankruptcy, and could lead to further inflows. This is a great point, however, my belief is that the improvement in the fiscal account will allow the interest rate to fall as well, having a small impact on flows. In fact, the reduction in the interest rate adjusted by risk drives inflows down. The assumption of Nouriel and Paulo is that the interest rate would remain as high even when country risk is falling. Paulo has a very good point that Brazil has a very high tax burden. When I mean counter cyclical policy I want the government to save – either by increasing the taxes or reducing expenditures. Actually, I have no problem in the case of Brazil, that you do a search and replace and whenever I say “increase taxes’ you put “reduce expenditures”

Let me reiterate why I think there is no chance of backfiring. If the flows that are going to Argentina, Colombia and Brazil are pursuing either high interest rates (as Marcio points out in his piece) or a real estate price boom, or an appreciating real exchange rate in general, then the fiscal improvement (which involves a reduction of the interest rate) should stop them. My father is Argentinean and I really do not like to use Chile as a “good” example – I’m lucky he does not speak English otherwise I will be hearing from him tomorrow. And he is retired! So he sends a continuum of emails – In any case, Chile is an example of how prudent fiscal policy does help tremendously the management of the real exchange rate appreciation, in Colombia, Brazil and Argentina we have not even asked the question.

Lastly, the purpose of these little pieces is to actually have this discussion. It has already help me understand the issue better. But we have to ask these questions. I feel that if we do not offer these countries a viable alternative they will end up just putting capital controls, or just accumulating reserves like crazy (by the way – external savings…) as the only response to the inflows. Which means that they will be unprepared when things turn around for the worse in a couple of years. I am not against capital controls in principle, but I think we can do much better, and we have to do much better. Hence, I am worried, and I am whining (I know…), but at least I’m willing.

8 Responses to "The un-Whining road of Fiscal Policy"

  1. Anonymous   May 25, 2007 at 7:58 am

    Some recent data suggest that the Colombian fiscal conditions are not that bad (large primary surplus). Does Colombia need to raise taxes or further control the fiscal deficit? Why? Based on which analysis?

  2. Anonymous   May 25, 2007 at 8:02 am

    Roberto, a very good reply. One specific issue: colombia is reintroducing capital controls on inflows (see story below)…do you agree or disagree with that step? You seem to be skeptical of capital controls on short term hot money inflows…why?  Colombia Announces Capital Controls to Curb Soaring Peso May 23, 2007 – 10:23 p.m.  BOGOTA, Colombia (AP) – Colombia announced capital controls on some foreign investments Wednesday to try to curb the soaring peso, which has made greater gains against the dollar this year than any other currency.  Finance Minister Oscar Zuluaga said that starting immediately, foreign portfolio investors will be required to deposit 40 percent of their investments in non-interest-bearing accounts in the Central Bank for six months. The measure is designed to absorb a surfeit of dollars and discourage speculative financial transactions.  The controls complement similar actions announced May 6 by the Central Bank to freeze 40 percent of offshore loans and deposits repatriated by local companies. The monetary authority has also steadily ratcheted up interest rates to blunt a resurgence of inflation.

  3. Alejandro   May 25, 2007 at 9:42 am

    Hi Roberto,  I liked your piece a lot but I don’t agree with your advice when countries are already running a significant primary fiscal surplus. It is not politically feasible to do so. If capital inflows are massive and unmanageable (can’t be fully sterilized) there is no sense in risking macroeconomic stability in order to preserve the full openness of capital accounts. In that situation, capital inflows have to be restricted and in this way, it will facilitate the management of exchange and monetary policies (similar to what Chile and Colombia did back in the nineties). After all, even though the restrictions are not perfect, they are only needed during a booming phase and it is perfectly clear that in developing nations those episodes don’t last forever. It’s essential that developing nations keep a stable and competitive real exchange rate (see Dani Rodrick’s comments and research among others and how it relates to higher rates of growth) and they shouldn’t sacrifice their objective because of one sided bets that become unmanageable. Regards,

  4. bsetser   May 25, 2007 at 3:07 pm

    A very interesting proposal. Your emphasis on the contribution of positive terms of trade shocks led me to think of the oil exporters, and, if i understand your argument correctly, it seems that you are in effect proposing that a broader range of commodity exporters engage in the same style of fiscal sterilization employed by some oil exporters …. i.e. using a positive terms of trade shock to build up the government’s offshore assets (fiscal accounts) to limit pressure for real appreciation.  For the oil exporters, the fact that most governments directly get the $ from the oil exports — whether from royalties and export taxes or from owning the state oil company — presumably facilitates fiscal sterilization. But presumably the same basic structure would work elsewhere as well.  Holding the fiscal reserves in dollars though poses some of the same problems the oil exporters have faced — they risk saving in a depreciating currency.

  5. Alberto Carrasquilla   May 25, 2007 at 5:47 pm

    Another little game, Roberto: suppose the “problem” was not a 15% appreciation over the last year but, rather, a 15% depreciation, combined not with 5% of GDP in capital inflows over the last few months, but rather 5% of GDP in outflows. Moreover, suppose the central bank had intervened currency markets by selling 30% of its initial reserves, not by buying them, and so on. You get the idea. Wouldn´t symmetry in argument force you to suggest that in order to deal with a situation quacking very much like a currency-crisis duck the country in question should…… implement a tax cut and speed up some more spending?

  6. Dr S   May 25, 2007 at 5:55 pm

    Since capitial is always chasing the highest return, or the cheapest cost of labor (be it actual or hidden a couple of layers down through higher interest rates); it would follow that raising the cost of labor (wages) would take care of the capitial inflow imbalance quite nicely, and distribute income more equitably, to boot.

  7. Roberto Rigobon   May 26, 2007 at 7:18 pm

    HI ALL, Great comments! Let me be precise about one issue. I never said the fiscal conditions in Colombia are bad. That has nothing to do with my point that fiscal policy can help resolve the problem of an appreciated exchange rate. I know they have a surplus, my point is that they should have a bigger one.  Alberto Carrasquilla asks a loaded question!   Let me try to provide a balanced answer. If we have a depreciated exchange rate because the price of commodities or exports is too low, and because the domestic interest rate is excessively low, I can assure you that the correct advice is to increase expenditures and cut taxes. That is exactly what we would advice a country that is suffering from deflation – such as Japan – and if that is the reason of the of the depreciation the policy advice is symmetric.  However, if the depreciation is taking place because the country is in the mist of a panic (as you might be tempted to read Alberto’s comment), then I would not advice to increase expenditures. The difference is that in the first one – a supply shock – the monetary authority can’t solve it without fiscal intervention – irrespectively if the shock is positive or negative. In the second one – a demand shock – the fiscal imbalance might be the cause, and in any case, the monetary authority can handle it.

  8. Anonymous   May 27, 2007 at 7:26 pm

    Roberto, you say you are not against capital controls. I understand your arguments for using fiscal policy to manage inflows. But fiscal policy works slowly and with lags. And fiscal policy alone – or even in company of easier monetary policy – may not be able to fully stem the inflows. If that were to be the case why not to introduce capital controls on hot money short term inflows. This is exactly what Colombia recently did; do you agree or disagree with such a policy action? nouriel