Historically, fiscal policy in the region has been at best acyclical, and often pro-cyclical: that is, in good economic times governments spend more and in bad times they cut back. This runs counter to conventional textbook recommendations for macroeconomic management, which counsel counter-cyclical fiscal policy, using government spending to ameliorate the worst effects of a recession for example. There is a political angle of course, but specifically economic problems for Latin America in running counter-cyclical policy include the small size of automatic stabilisers in the region and its relatively narrow scope for discretionary policy.
In Latin America, the sort of automatic stabilisers that benefit other economies have very little impact because of the small tax base (on the revenue side) and low unemployment benefits (on the spending side – see Chapters 1 and 2 for more on this). Output semi-elasticity of total taxes is around 0.2 – only half the size of observed automatic responses in OECD economies (Figure 0.8).8
Counter-cyclical fiscal policy is thus left to discretionary measures. The scope for these in turn is typically constrained by a significant deterioration of fiscal balances during recessionary episodes, led by weakening commodity-related revenues. Such revenues tend to be both highly responsive and positively correlated with the economic cycle and can have a significant, if temporary, effect on fiscal balances. Rather than automatic stabilisers, many economies in fact faced an "automatic fiscal deficit" further constraining scope for counter-cyclical measures.
Figure 0.8. Output elasticity of total taxes
Figure 0.9 shows net fiscal structural balances between 1990 and 2009 for eight countries in the region. Structural fiscal balances (the black line) represent the fiscal balance if GDP had been at potential with no cyclical gap.9 Thus, if other revenues and spending grow smoothly at a rate equal to potential growth, the structural budget balance would remain constant. A decrease in the structural balance can thus be interpreted as a net "discretionary" stimulus (be it from a reduction in the growth of tax revenues or higher growth in fiscal spending).
Comparing the black line with the bars in Figure 0.9, discretionary policy thus defined is clearly pro-cyclical in Argentina and Uruguay, and acyclical in the remainder of the countries in the figure. Argentina’s and Uruguay’s pro-cyclicality was most evident during the 2001 crisis. During this their governments had no fiscal scope to counteract economic collapse – fiscal resources and access to capital were both severely reduced, resulting in a painfully pro-cyclical response to the crash. Other countries, while less obviously pro-cyclical, exhibit no clear counter-cyclicality. In most countries, boom years without precautionary fiscal policy are followed by recessions during which credit is unavailable. How can this pattern be broken?
Governments have an opportunity to establish their credibility during the height of the economic cycle. Because they cannot rely on automatic stabilisers, it is not enough to aim at a balanced structural budget. Governments need a pro-cyclical structural balance, building assets on top of any accumulated by automatic stabilisers, by running precautionary surpluses in good times that may be put to use during recessions. Figure 0.9 shows that Chile, and to a lesser extent Peru, did just this in the years leading up to the crisis, maintaining a positive structural balance when enjoying a commodity boom.
In most Latin American countries, the post-crisis stimulus programmes did not jeopardise the credit standing of their governments. This suggests that countries designed their packages taking sustainability and credibility constraints seriously.
Building market credibility is expensive. Fighting demands for increased spending in good times, when resources are by definition available, means governments must expend large amounts of political capital to exercise restraint. It is also economically costly since governments might need to save more than the level that would be dictated by a simple precautionary "rainy-day" motive while they first build their credibility.
Figure 0.9. Cycles and observed primary and structural balances (percentage points of GDP) Mexico & Chile
Figure 0.9. Uruguay & Argentina
Figure 0.9. Costa Rica & Peru
Figure 0.9. Colombia & Brazil
The funds so accumulated can be used to reduce government debt, but they can also be used to create reserves or precautionary funds. These have the advantage of being able to provide liquidity during a liquidity crunch. They serve also as visible collateral, discouraging the creation of self-fulfilling capital crunches and/or interest-rate rises.
Such fiscal discipline is not easy. Aside from the political pressures, it is technically hard to determine how much of output growth during boom years is permanent (affecting potential growth) and how much is cyclical – a combination of problems that usually results in over-optimistic forecasts. This uncertainty exists when making such estimates in any economy, but is accentuated in emerging ones where both production and terms of trade are more volatile. Nevertheless, successive reforms have given hope that, at last, a significant and long-lasting improvement is in the offing.
Figure 0.10. Fiscal-resilience index (pre-1980 crisis, pre-2009 crisis, 2009)
Prudence builds resources, but these are finite and use of the war chest to fund counter-cyclical measures depletes it, particularly over the course of a prolonged crisis (Figure 0.10). It is worth noting, nonetheless, that by the end of 2009 fiscal policy remained more resilient than at the onset of the 1980s crisis. Were the global crisis to enter a new and deeper phase, other things being equal, the economies of Latin America might expect to suffer more than they have in their most recent recession, but still far from the debacle that followed the 1980s. The exception to this brighter pattern is Venezuela, which shows steady weakening from its once leading position.