What Small CountriesWhat Small CountriesCan Teach the WorldCan Teach the World

Jeffrey Frankel Jeffrey Frankel Harpel Professor of Capital Formation & Growth,Harpel Professor of Capital Formation & Growth,

Harvard UniversityHarvard University

& Director of Program in International Finance & & Director of Program in International Finance & Macroeconomics,Macroeconomics,

National Bureau of Economic ResearchNational Bureau of Economic Research

NBER Session, NABE Annual Meeting, Dallas, NBER Session, NABE Annual Meeting, Dallas, September 11, 2011September 11, 2011

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Countries need a Countries need a modelmodel

• In the past, countries choosing social systems, development strategies, or specific institutions usually looked to the big powers for inspiration

• Europe, • USSR,• Japan, • US. Project Syndicate , , Oct.2010.Oct.2010.

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• Two decades ago, many thought Two decades ago, many thought the lesson of the 1980s had been that the lesson of the 1980s had been that Japan’s Japan’s variant of capitalism was the best model:variant of capitalism was the best model:– Including such institutions as:Including such institutions as:

• Strategic trade policy, Strategic trade policy, • relationship banking, relationship banking, • life-time employment…life-time employment…

– Other countries should follow it. Other countries should follow it.

• The Japanese model The Japanese model quickly lost its luster in the 1990s.quickly lost its luster in the 1990s.

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• OneOne decade ago, many thought decade ago, many thought that the lesson of the 1990s had been that that the lesson of the 1990s had been that the US variant of capitalism was the best the US variant of capitalism was the best model –model –– Including American-style corporate governance:Including American-style corporate governance:

• Securities markets,Securities markets,• accounting standards,accounting standards,• compensation for CEOs (options…)compensation for CEOs (options…)

– Other countries should follow. Other countries should follow.

• The American model in turn The American model in turn lost its attractiveness in the decade of the lost its attractiveness in the decade of the 2000s.2000s.

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To whom should countries To whom should countries around the world look for around the world look for

inspiration, now? inspiration, now? 

European Financial Review, , 2011.2011.

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Meanwhile, many smaller Meanwhile, many smaller countriescountries

on the periphery have on the periphery have experimented with policies experimented with policies and institutions that could and institutions that could

usefully be adopted by usefully be adopted by others.others.

Institutions worth emulating.

European Financial Review, , 2011.2011.

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• Countries that are small, newly independent, Countries that are small, newly independent, far-away, or emerging from a devastating war, far-away, or emerging from a devastating war, are often more free to experiment, are often more free to experiment, – than is the US or other large established countries.than is the US or other large established countries.

• Not all the experiments will succeed. Not all the experiments will succeed.

• But some will. But some will.

• The results may include useful lessonsThe results may include useful lessons. .

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Some micro examplesSome micro examples

• Costa Rica in Central America Costa Rica in Central America and Mauritius in Africa and Mauritius in Africa each pulled ahead of its each pulled ahead of its regional peers long ago.  regional peers long ago. 

• Among other decisions that worked out Among other decisions that worked out well for them, both countries have well for them, both countries have foregone a standing army. foregone a standing army. – The result in both cases: no-coup histories; The result in both cases: no-coup histories; – and financial savings that were used for and financial savings that were used for

good things,good things,• such as education and investment. such as education and investment. 

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• Singapore achieved rich Singapore achieved rich country status country status with a unique development with a unique development strategy. strategy. 

• Among its many innovations Among its many innovations were: were: – a paternalistic approach to a paternalistic approach to

saving; and saving; and – congestion pricing congestion pricing

for auto traffic. for auto traffic.

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The price mechanism to The price mechanism to

address traffic congestion address traffic congestion • has been emulated by London has been emulated by London since 2003.since 2003.

• More cities More cities should follow. should follow.

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CCT programsCCT programs

• Mexico pioneered Conditional Cash Transfers Mexico pioneered Conditional Cash Transfers (the OPORTUNIDADES program — (the OPORTUNIDADES program — originally called PROGRESA, launched in 1998). originally called PROGRESA, launched in 1998). 

• CCT programs have subsequently CCT programs have subsequently been emulated by many developing countries.  been emulated by many developing countries.  – Notably Lula’s BolsaNotably Lula’s Bolsa Familia in Brazil.Familia in Brazil.

• Two revolutions in one: Two revolutions in one:  – (1) the specific idea of making poverty transfers contingent (1) the specific idea of making poverty transfers contingent

on child school attendance (which has been emulated even on child school attendance (which has been emulated even in NYC) in NYC)

– (2) the methodological idea of conducting controlled (2) the methodological idea of conducting controlled experiments to find out what policies work or don’t work,experiments to find out what policies work or don’t work,• which fed into the exciting Randomized Control Trials movement. which fed into the exciting Randomized Control Trials movement. 

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Some small advanced Some small advanced countries countries

also have lessons to offer.  also have lessons to offer.  

• New Zealand led the way New Zealand led the way with Inflation Targeting, with Inflation Targeting, – along with many late-1980s liberalization along with many late-1980s liberalization

reforms.   reforms.   – Its Labor Party could even be given credit Its Labor Party could even be given credit

for pioneering the principle that some left-for pioneering the principle that some left-of-center governments can achieve of-center governments can achieve economic liberalization better than their economic liberalization better than their right-of-center opponents.right-of-center opponents.

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• Ireland stressed Ireland stressed Foreign Direct Investment. Foreign Direct Investment. 

• Estonia led the way in Estonia led the way in

simplifying its tax system simplifying its tax system by means of a successful flat tax by means of a successful flat tax in 1994, in 1994,

• followed by Slovakia followed by Slovakia • and other small countries in and other small countries in

Central/Eastern Europe.Central/Eastern Europe.

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• In highlighting some very specific institutions In highlighting some very specific institutions that could be usefully applied elsewhere, I that could be usefully applied elsewhere, I don’t mean to suggest that they can be don’t mean to suggest that they can be effortlessly translated from one national effortlessly translated from one national context to another. context to another.

• Nor do I mean to suggest that these examples Nor do I mean to suggest that these examples are entirely responsible for the success are entirely responsible for the success of the economies identified.  of the economies identified. 

– Indeed a few of these countries Indeed a few of these countries have recently been wrestling with severe have recently been wrestling with severe problems.problems.

• But a country doesn’t have to be large like But a country doesn’t have to be large like the U.S. to serve as a model for others.the U.S. to serve as a model for others.

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My most important My most important example: example:

Chile’s fiscal institutionsChile’s fiscal institutions• Most developing countries in the past Most developing countries in the past

suffered from procyclical fiscal policysuffered from procyclical fiscal policy ::– In boom times they would increase spending,In boom times they would increase spending,

– in downturns they were forced to cut back;in downturns they were forced to cut back;

– thereby exacerbating the business cycle.thereby exacerbating the business cycle.• Kaminsky, Reinhart & Vegh (2004), Talvi & Végh (2005), Alesina, Campante & TabelliniKaminsky, Reinhart & Vegh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini ( (2008), 2008),

Mendoza & Oviedo (2006), Ilzetski & Vegh (2008) and Medas & Zakharova (2009).Mendoza & Oviedo (2006), Ilzetski & Vegh (2008) and Medas & Zakharova (2009).

– Especially Latin American commodity-exporters.Especially Latin American commodity-exporters.• Gavin & Perotti (1997), Calderón & Schmidt-Hebbel (2003) and Perry (2003).Gavin & Perotti (1997), Calderón & Schmidt-Hebbel (2003) and Perry (2003).

• The correlation of govt. spending & GDP The correlation of govt. spending & GDP >> 0; 0;– almost 1 for Oman, for example.almost 1 for Oman, for example.

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Kaminsky, Reinhart & Vegh (2004)

GG always used to be pro-cyclical always used to be pro-cyclical for most developing countries.for most developing countries.

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Correlations between Government spending & GDP Correlations between Government spending & GDP 1960-20021960-2002

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Historic role reversalHistoric role reversal

• Since 2000, one third of the EM/developing countries Since 2000, one third of the EM/developing countries have “graduated” from procyclical fiscal policy have “graduated” from procyclical fiscal policy to countercyclical,to countercyclical,– running primary surpluses ,running primary surpluses ,

providing for future pension costs, & providing for future pension costs, & cutting debt during the 2002-07 boom.cutting debt during the 2002-07 boom.

– By 2007, Latin America had cut its debt to 33% of GDP, By 2007, Latin America had cut its debt to 33% of GDP, • as compared to 63 % in the United States. as compared to 63 % in the United States.

– allowing easing in the 2008-09 global recession.allowing easing in the 2008-09 global recession.

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Correlations between Government Correlations between Government spending & GDP spending & GDP

2000-20092000-2009

In the last decade, In the last decade, about 1/3 developing countries about 1/3 developing countries

switched to switched to countercyclicalcountercyclical fiscal policy: fiscal policy:Negative correlation of G & GDP.Negative correlation of G & GDP.

Frankel, Vegh & Vuletin (2011)

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• Debt levelsDebt levels in top 20 emerging markets are now in top 20 emerging markets are now< half those in rich countries< half those in rich countries (debt/GDP ratios ≈ 80%)(debt/GDP ratios ≈ 80%) . .

• Some emerging markets have earned Some emerging markets have earned credit ratingscredit ratings higher than some so-called advanced countries.higher than some so-called advanced countries.

• During the same period when these countries During the same period when these countries learned how to run countercyclical policy, learned how to run countercyclical policy, it seems that the US and Europe forgot how.it seems that the US and Europe forgot how.– They allowed large deficits during the expansion,They allowed large deficits during the expansion,– and now feel constrained to cut spending, despite depressed GDP.and now feel constrained to cut spending, despite depressed GDP.

• How did they do it?How did they do it?

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Chile in 2000 Chile in 2000 instituted a structural instituted a structural

budget rulebudget rule• The institution was formalized in law in 2006.The institution was formalized in law in 2006.

• The rule: the government must set a target The rule: the government must set a target for the structural budget deficit,for the structural budget deficit,– which President Bachelet set at 0,which President Bachelet set at 0,

• where “structural” is defined as output & copper price where “structural” is defined as output & copper price equal to their long-run trend values.equal to their long-run trend values.

• I.e., in a boom the government I.e., in a boom the government can only spend increased revenues can only spend increased revenues that are deemed permanent; that are deemed permanent; any temporary copper bonanzas any temporary copper bonanzas must be saved.must be saved.

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• Chile’s fiscal position strengthened immediately.Chile’s fiscal position strengthened immediately. – allowing national saving to rise from 21% to 24% by 2005.allowing national saving to rise from 21% to 24% by 2005.

• Government debt fell sharply as a share of GDP Government debt fell sharply as a share of GDP and the sovereign spread gradually declined. and the sovereign spread gradually declined.

• By 2006, Chile achieved a sovereign debt rating of A, By 2006, Chile achieved a sovereign debt rating of A,

• By 2007, Chile had become a net creditor. By 2007, Chile had become a net creditor.

• By 2010, its sovereign rating had climbed to A+, By 2010, its sovereign rating had climbed to A+, – ahead of some advanced countries: ahead of some advanced countries:

– Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).

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• In 2007-08, with copper prices spiking upward, In 2007-08, with copper prices spiking upward, the Bachelet government was under the Bachelet government was under intense pressure to spend the revenue.intense pressure to spend the revenue.– She & Fin.Min.Velasco held to the rule, saving most of it.She & Fin.Min.Velasco held to the rule, saving most of it.– Their popularity ratings fell sharply.Their popularity ratings fell sharply.

• When the 2009 recession hit and the copper price When the 2009 recession hit and the copper price came back down, came back down, the government the government raised spending, raised spending, mitigating mitigating the downturn.the downturn.– The Ministers’The Ministers’ popularity popularity

reached historic reached historic highshighs in 2009.in 2009.

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• A budget target of zero may sound familiarA budget target of zero may sound familiar– like the budget deficit ceilings that supposedly constrain like the budget deficit ceilings that supposedly constrain

members of euroland members of euroland (deficits < 3 % of GDP under (deficits < 3 % of GDP under the Stability & Growth Pact) the Stability & Growth Pact)

– or like the U.S. proposals or like the U.S. proposals for a Balanced Budget Amendment (deficit = 0).for a Balanced Budget Amendment (deficit = 0).       

• But those attempts fail. Two reasons:But those attempts fail. Two reasons:– (1) They are too rigid to allow the need for deficits (1) They are too rigid to allow the need for deficits

in recessions, counterbalanced by surpluses in good times. in recessions, counterbalanced by surpluses in good times. • and lack credibility from the beginning.and lack credibility from the beginning.

– But even But even structuralstructural budget rules fail. budget rules fail. – Why? My hypothesis:Why? My hypothesis:– (2) Politicians make overly optimistic forecasts (2) Politicians make overly optimistic forecasts

of growth & budgets, of growth & budgets, • thus avoiding cutbacksthus avoiding cutbacks..

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Budget balance forecast error as % of GDP, Full dataset

(1) (2) (3)

One year ahead Two years ahead Three years ahead

GDP relative to trend

0.093***(0.019)

0.258***(0.040)

0.289***(0.063)

Constant 0.201 0.649*** 1.364***(0.197) (0.231) (0.348)

Observations 398 300 179Variable is lagged so that it lines up with the year in which the forecast was made.*** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country.

Official budget forecasts are biased toward optimismespecially if GDP is currently high & especially at longer horizons

33 countries

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Budget balance forecast error as a % of GDP, Full Dataset(1) (2) (3) (4)

One year ahead

Two years ahead

One year ahead

Two years ahead

SGPdummy 0.658 0.905** 0.407 0.276(0.398) (0.406) (0.355) (0.438)

SGP dummy * (GDP - trend)

0.189**(0.0828)

0.497***(0.107)

Constant 0.0330 0.466* 0.0330 0.466*(0.228) (0.248) (0.229) (0.249)

Observations 399 300 398 300

Official budget forecasts are more biased toward optimismin countries subject to a budget deficit rule (SGP)

*** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country.

33 countries

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The crucial institutional innovation in ChileThe crucial institutional innovation in Chile

• Chile has avoided over-optimistic official forecasts,Chile has avoided over-optimistic official forecasts,– especially the historic pattern of especially the historic pattern of

over-exuberance in commodity booms.over-exuberance in commodity booms.– How?How?

• The estimation of the long-term path The estimation of the long-term path for GDP & the copper price for GDP & the copper price -- and so how much of a copper bonanza can be spent ---- and so how much of a copper bonanza can be spent -- is made by two panels of independent experts,is made by two panels of independent experts,– and thus is insulated from political pressure & wishful thinking.and thus is insulated from political pressure & wishful thinking.

• Other countries could usefully emulate Chile’s innovationOther countries could usefully emulate Chile’s innovation– or in other ways delegate to independent agencies or in other ways delegate to independent agencies

estimation of structural budget deficit paths.estimation of structural budget deficit paths.

27European Financial Review,, 2011. 2011.

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Appendix: Appendix: US fiscal policyUS fiscal policy

since 2001since 2001

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The US public debate is framed as a battle between The US public debate is framed as a battle between conservatives who philosophically believe in strongconservatives who philosophically believe in strong

budgets & small government, budgets & small government, and and liberals who do not.liberals who do not.

• The right goal is budgets that allow The right goal is budgets that allow surpluses in booms and deficits in recession.surpluses in booms and deficits in recession.

•The correlation between how loudly an American politician proclaims a belief in fiscal conservatism and how likely he is to take corresponding policy steps The correlation between how loudly an American politician proclaims a belief in fiscal conservatism and how likely he is to take corresponding policy steps < 0< 0..

Not the right way to characterize the question.Not the right way to characterize the question.

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• The U.S. is an example of those overly optimistic government The U.S. is an example of those overly optimistic government budget forecasts.budget forecasts.

• When the Bush administration took office in January 2001,When the Bush administration took office in January 2001,

it forecast $5 trillion in cumulative budget surpluses for the decade.it forecast $5 trillion in cumulative budget surpluses for the decade.

• Its over-optimism took three forms:Its over-optimism took three forms:– 1) Overly optimistic economic/technical assumptions1) Overly optimistic economic/technical assumptions

• E.g., not allowing for a possible future recession.E.g., not allowing for a possible future recession.

– 2) Faulty economic theories regarding tax cuts: 2) Faulty economic theories regarding tax cuts: • the “Laffer Hypothesis” and “Starve the Beast”the “Laffer Hypothesis” and “Starve the Beast”

– 3) Tricks to force CBO to score the base budget3) Tricks to force CBO to score the base budget• E.g., phony sun-setting of tax cuts in 2010, 2012E.g., phony sun-setting of tax cuts in 2010, 2012• Pretending each year that the wars in Iraq & Afghanistan would end.Pretending each year that the wars in Iraq & Afghanistan would end.

US fiscal policy 2001-08US fiscal policy 2001-08

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Budget forecasts by the Bush Budget forecasts by the Bush White House then had to be White House then had to be

revised down every yearrevised down every year

Jan.2001

Aug.2001

Jan.2002

Aug.2002

Jan.2003

Aug.2003

Jan.2004

-500

-400

-300

-200

-100

0

100

200

300

400U

S$ b

n

2002 2003 2004Source: OMB

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US fiscal policy over the past decade,US fiscal policy over the past decade, continuedcontinued

• The forecasted surpluses helped Bush launch The forecasted surpluses helped Bush launch a 10-year path of un-conservative fiscal policy:a 10-year path of un-conservative fiscal policy:– tax cuts tax cuts – & accelerated spending & accelerated spending

• >> twice Clinton’s rate of spending growth. twice Clinton’s rate of spending growth.

• The results:The results:

– a cumulative $5 trillion in decade budget a cumulative $5 trillion in decade budget deficitsdeficits..

– Today, in 2011, although the economy is weak, Today, in 2011, although the economy is weak, Washington feels constrained by its debt Washington feels constrained by its debt to withdraw fiscal stimulus.to withdraw fiscal stimulus.

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Faulty tax cut theory I -- Laffer Faulty tax cut theory I -- Laffer Hypothesis:Hypothesis:

“Tax cuts stimulate activity enough to “Tax cuts stimulate activity enough to raise revenue”raise revenue”

StatisticStatistical al evidence evidence against against itit

Explicit Explicit disavowal by disavowal by presidential presidential economic economic advisersadvisers

Did these Did these Administrations, Administrations, then, never actually then, never actually claim the Laffer claim the Laffer Proposition?Proposition?

Goolsbee Goolsbee (1998, 1999, (1998, 1999, 2000), Kasten, 2000), Kasten, Weiner Weiner &&

Woodward Woodward (1999); (1999); Burman & Randolph (1994), Auerbach & Siegel (2000).

Reagan’s advisers:

Martin Feldstein (1985): “Each of those predictions has proven to be wrong.”

Feldstein (1994).

Pres. Reagan Pres. Reagan 7/7/81 7/7/81 :: “…our kind of tax cut will so “…our kind of tax cut will so stimulate the economy that we stimulate the economy that we will actually increase government will actually increase government revenues.” revenues.”

Treas.Sec. Don ReganTreas.Sec. Don Regan (1988)(1988)

Gale & Potter Gale & Potter (2002), Gale & (2002), Gale & Kotlikoff Kotlikoff (2004); Uhlig & (2004); Uhlig & Trabandt Trabandt (2006), (2006), Heijman & van Heijman & van Ophem (2005)Ophem (2005)

Bush’s advisers:

Greg Mankiw (1998): “…history failed to confirm Laffer’s conjecture …”

Glenn Hubbard (2003).

Pres. GWB Pres. GWB 11/13/2002, 11/13/2002, 7/24/03, 8/6/05, 8/22/06, 7/24/03, 8/6/05, 8/22/06, 7/11/06;7/11/06;

VP VP Cheney 1/30/03, 2/9/06;

Sec.Snow 2/7/06; Press

Sec.Fleischer 1/8/03;

OMB Dir. Bolten 7/03, 12/10/03, 7/05.

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Faulty tax cut theory II – Faulty tax cut theory II – The Starve the Beast The Starve the Beast

Hypothesis:Hypothesis:“Tax cuts lower revenue which forces “Tax cuts lower revenue which forces

spending cuts.”spending cuts.”Statistical evidence against the Statistical evidence against the

HypothesisHypothesisWilliam Niskanen (2002); -- (2004) “Starve the Beast Does Not Work,” Cato Policy Report 26, March;

-- (2006), “Limiting Government: The Failure of ‘Starve the Beast’,” Cato Journal, Fall. Gale & Orszag (2004), "Bush Administration Tax Policy: Revenue and Budget Effects," Tax AnalystsRomer & Romer (2007) “Do Tax Cuts Starve the Beast: The Effect of Tax Changes on Government Spending,” NBER WP no. 13548

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Vs. the 1990s: The Shared Sacrifice approach succeeded in Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spendingeliminating budget deficits, importantly by slowing spending. .

-3

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Spending and Budget Balance(inverse) as % of GDP (Current US$)

Spending/GDP Budget Balance/GDP

R. R

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J. C

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G.H

.W.

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Source: OMB

ρ = 0.86

““Starve the Beast” does not work: Tax cuts were Starve the Beast” does not work: Tax cuts were not associated with spending cuts. To the contrary.not associated with spending cuts. To the contrary.

|Tax cut regime | | Tax cut regime || Tcr |Shared sacrifice

regime |

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This talk draws on the following This talk draws on the following writingswritings

• Some Big Ideas from Small Countries, European Financial Review, ,

May 2011.May 2011.

• ""Big Ideas from Small Countries,“ ,“ in in Project Syndicate , , Oct.2010. Oct.2010.  Blog ..

• "Mauritius: African Success Story," forthcoming, S.Edwards, S.Johnson, & forthcoming, S.Edwards, S.Johnson, & D.Weil,D.Weil, eds.  NBER WP 16569, Dec.2010.eds.  NBER WP 16569, Dec.2010.

•   "Over-optimism in Forecasts by Official Budget Agencies and Its "Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Implications," forthcoming,forthcoming, Oxford Review of Economic PolicyOxford Review of Economic Policy, 2011.  , 2011.  NBER WP NBER WP 17239. 17239.

• ““A Solution to Fiscal Procyclicality:  The Structural Budget A Solution to Fiscal Procyclicality:  The Structural Budget Institutions Pioneered by Chile,” Institutions Pioneered by Chile,” forthcoming,forthcoming, Fiscal Policy and Fiscal Policy and Macroeconomic Performance, Macroeconomic Performance,   Series on Central Banking Analysis, & Economic Policies , Nov. 2011.   NBER WP 16945. Series on Central Banking Analysis, & Economic Policies , Nov. 2011.   NBER WP 16945.

• A Lesson from the South for Fiscal Policy in the US & Other A Lesson from the South for Fiscal Policy in the US & Other Advanced Countries,"Advanced Countries," Comparative Economic StudiesComparative Economic Studies,, Sept.Sept. 2011. 2011. 

• ““On Graduation from Procyclicality,”On Graduation from Procyclicality,”withwith C.VéghC.Végh && G.Vuletin, Aug.G.Vuletin, Aug.20112011. VoxEU.. VoxEU.

• ““Snake-Oil Tax Cuts,” Snake-Oil Tax Cuts,”   EPI Briefing Paper 221, 2008.EPI Briefing Paper 221, 2008.