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 problems, 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. (See graphs below.) There may have been multiple reasons for this, but perhaps the most important 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.  Why the change?  

         It was not due to an improvement in overall economic circumstances:  in the meantime the global recession had hit.  Copper prices had fallen abruptly.  (Chile’s economy is dependent on this metal, which constitutes as much as 3/4 of its exports.)   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.  

Source for charts:
Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,”  Commodities Workshop, World Bank, Sept. 17, 2009.

            Some credit should go to previous governments, who initiated an innovative fiscal institution.  But much credit should go to Bachelet and Velasco, who enshrined the general framework in law and abided by it when it was most difficult to do so politically.  (They introduced a Fiscal Responsibility Bill in 2006, which gave legal force to the role of the structural budget, and created a Pension Reserve Fund and a Social and Economic Stabilization Fund, the latter a replacement for the existing Copper Stabilization Funds.)   

            Chile’s fiscal policy is governed by a set of rules.   The first one is a target for the overall budget surplus (originally set at 1 % of GDP, then lowered to ½ % of GDP, and again to 0 in March 2009).    This may sound like the budget deficit ceilings that supposedly constrain members of euroland (deficits of 3 % of GDP under the Stability and Growth Pact) or like the Gramm-Rudman legislation that the US tried in the 1980s.    But those attempts have failed.  They are too rigid to allow the need for deficits in recessions, counterbalanced by surpluses in good times.  The alternative of letting politicians explain away any deficits 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 (also the same for molybdenum).   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.    As a result, the fiscal surplus reached almost 9 % when copper prices were high.  The country paid down its debt to a mere 4 % of GDP and it saved about 12 % of GDP in the sovereign wealth fund.    This in turn has allowed a very substantial fiscal easing since 2008, when the stimulus was most sorely needed.

            Any country, but especially commodity-producers, could usefully apply variants of the Chilean fiscal device.  Given that many developing countries are prone to weak institutions, a useful reinforcement of the Chilean idea would be to codify the details legally, and 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 reform needed in so many countries where the politicians have repeatedly proven themselves unable to maintain long-term fiscal discipline.  

[Earlier version posted at RGE Monitor.]