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.