Achieving Long-Term Fiscal Discipline: A Lesson from Chile

As Chile’s President Michelle Bachelet prepares to hand over power to her newly elected successor, she remains extraordinarily popular.  It is worth reflecting on the fiscal aspects of her term in office, as Chile has important lessons for other countries struggling with fundamental long-term budget questions, which includes a lot of countries right now.

As recently as June 2008, President Bachelet and her Finance Minister, Andres Velasco, had the lowest approval ratings of any President or Finance Minister, respectively, since the return of democracy to Chile. There were undoubtedly multiple reasons for this, but one was popular resentment that the two had resisted intense pressure to spend the receipts from copper exports, which at the time were soaring along with world copper prices.  One year later, in the summer of 2009, the pair had the highest approval ratings of any President and Finance Minister since the return of democracy to Chile.  Why the change?   Not an improvement in overall economic circumstances:  in the meantime the global recession had hit.  Copper prices had fallen abruptly.  But the government had increased spending sharply, using the assets that it had acquired during the copper boom, and thereby moderating the downturn.   Saving for a rainy day made the officials heroes, now that the rainy day had come.   Chile has achieved what few commodity-producing developing countries have achieved:  a truly countercyclical fiscal policy. 

The two policy makers deserved a large share of the credit personally. (The Bachelet government introduced a Fiscal Responsibility Bill in 2006, which added a Pension Reserve Fund and a Social and Economic Stabilization Fund, the latter a replacement for the existing Copper Stabilization Funds.)   But a large share must also go to institutions that had already been put in place by previous governments.  It is these institutions that many other countries could usefully emulate.

Chile’s fiscal policy is governed by a set of rules.   The first one is a long-term target for the overall budget surplus (originally 1 % of GDP, then lowered to ½ % of GDP).    This much is like the budget deficit ceilings that supposedly constrain members of the euro (deficits of 3 % of GDP under the Stability and Growth Pact) or occasional U.S. proposals for a Balanced Budget Amendment (zero deficit).    Those attempts have failed, because they are too rigid to allow the need for deficits in recessions, counterbalanced by surpluses in good times.  But the alternative of letting politicians explain away any deficit by declaring them the result of slower growth than expected also does not work, because it imposes no discipline. 

Under the Chilean rules, the government can run a deficit larger than the target to the extent that:(1) output falls short of potential, in a recession, or (2) the price of copper is below its medium-term (10-year) equilibrium, with the key institutional innovation that there are two panels of experts whose job it is each mid-year to make the judgments, respectively, what is the output gap and what is the medium term equilibrium price of copper.   Thus in the copper boom of 2003-2008 when, as usual, the political pressure was to declare the increase in the price of copper permanent thereby justifying spending on a par with export earnings, the expert panel ruled that most of the price increase was temporary so that most of the earnings had to be saved.  This turned out to be right, as the 2008 spike was indeed temporary.   

Any country, but especially commodity-producers, could usefully apply variants of the Chilean fiscal device.  Given that many developing countries are more prone to weak institutions (Greece comes to mind), a useful reinforcement of the Chilean idea would be to give legal independence to the panels.    There could a requirement regarding the professional qualifications of the members and laws protecting them from being fired, as there are for governors of independent central banks.   The principle of a separation of decision-making powers should be retained:  the rules as interpreted by the panels determine the total amount of spending or budget deficits, while the elected political leaders determine how that total is allocated.   This may be just the sort of structural reform needed in so many countries where the politicians have repeatedly proven themselves unable to maintain long-term budgetary discipline. (Greece comes to mind.)

Originally published at Jeff Frankel’s Weblog and reproduced here with the author’s permission.