1. Targeting the Structural Balance Laura Dos Reis, Paolo Manasse and Ugo Panizza XXIV Meeting of the Latin American Network of Central Banks and Finance Ministries Inter-American Development Bank Washington, DC, October 19, 2006

2. Motivation Should a country adopt a target for fiscal policy? Should “fiscal rules” be used? Should they target a structural balance?

3. Outline The Cyclically Adjusted Balance: Definition, Interpretation and Implementation The Case for a Structural Balance Target: Deficit Bias, Procyclicality The Case for Discretionary Fiscal Policy: Virtuous Politicians, Creative Accounting, Irrelevance

4. The Cyclically Adjusted Balance Definition: –What part in the changes in the fiscal stance is due to changes in the environment and what part to changes in policy? Five possible interpretations (Blanchard, 1990) 1.Index of discretionary fiscal policy 2.Index of permanent (“structural”) fiscal stance 3.Index of how fiscal policy affects the economy 4.Index of fiscal sustainability 5.Policy target

5. Problems of Interpretation CAB as a measure of discretionary fiscal policy => active vs. passive CAB as a measure of “structural” policy stance => temporary vs. permanent shocks CAB as an indicator of the impact of fiscal shocks on the economy => balanced budget multiplier CAB as an indicator of fiscal sustainability => real interest rate, rate of growth, debt structure CAB as policy target : => optimal level of public savings? Let automatic stabilizer operate?

6. Problems of Computation Decomposition between trend and cycle –The detrending method matters –“Forward looking filters” require future data –Data revisions affect the decomposition

7. Data revision and CAB for Brazil Figure 1: 1990 Brazil’s Output Gap Measured in Different Periods -3.5 -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Year of measurement Output Gap in 1990 (% of Potential output)

8. Impact of GDP Revisions on CABs: Spring 2003 vs. Autumn 2003 EC Release Revision to GDP Growth Rates (percentage points) Elasticity of Balance to Cycle Revisions to CABs (percentage points of GDP) 2001 2002 2003 2004 2001 2002 2003 2004 2005 Austria 0.1 0.3 -0.2 -0.1 0.3 0.00 0.02 0.05 0.08 0.12 Belgium -0.1 0.0 -0.4 -0.5 0.6 -0.16 -0.20 -0.24 -0.26 - Finland 0.6 -0.8 -0.4 0.7 -0.04 -0.09 -0.17 -0.29 -0.45 France 0.3 0.1 -1.1 -0.6 0.4 -0.08 -0.15 -0.23 -0.31 -0.39 0.08 0.18 0.25 0.32 The Netherlands 0.0 -0.1 -1.4 -1.1 0.7 -0.31 -0.52 -0.78 -1.06 -1.33 Average absolute revision 0.2 0.3 0.7 0.6 0.17 0.24 0.33 0.44 0.54

9. Problems of Computation Decomposition between trend and cycle –Output = Trend + Cycle –What detrending method should be used? –Most “filters” (HP) need future data –Data revisions affect the decomposition –Things are even more complicated in EM countries where it is not clear what is the trend and what is the cycle (Aguiar and Gopinath, 2004)

10. Problems of Computation Estimate Revenue & Expenditure elasticities to output => Balance elasticity -Information on the source of change in the balance -But not directly relevant for the question of CAB -Estimation errors?

11. Outline The Cyclically Adjusted Balance The Case for a Structural Balance Target The Case for Discretionary Fiscal Policy

12. The Case for Structural Balance A fiscal rule can reduce the deficit bias of myopic politicians –However a simple fiscal rule can lead to procyclicality (tradeoff credibility stabilization) A fiscal rule defined in terms of a CAB can reduce deficit bias while allowing for the conduct of countercyclical fiscal policy

13. The Case for Structural Balance Procyclicality –First documented by Gavin and Perotti (1997) and then corroborated by several others –Also present in industrial countries but only during good times –Possible explanations Poor institutions Procyclical capital flows Rules? –Evidence that fiscal rules reduce the deficit bias and also procyclicality

14. The Case for Structural Balance Fiscal Rules, Deficit Bias and Procyclical Policy Dependent Variable: Primary surplus/GDP

15. Outline The Cyclically Adjusted Balance The Case for a Structural Balance Target The Case for Discretionary Fiscal Policy

16. The Case for Discretion Unnecessary constraints to virtuous politicians –When institutional quality is controlled for, fiscal rules do not matter anymore (Manasse (2006)) –So rules maybe endogenous –Useless but not harmful: they may even give some ammunition to a virtuous policy-maker –However, a CAB rule may force a virtuous politicians to spend too much if people think that trend growth has increased

17. The Case for Discretion Creative accounting –Rules may create incentives for creative accounting –The incentive for creative accounting may be reduced or raised by a simpler (i.e unadjusted balance based) rule More difficult to trick the data More incentive to trick the data

18. The Case for Discretion Setting limit on deficits may not suffice for preventing debt explosions –Change in Debt = Deficit+ Stock-Flow Adj –SF is huge (creative accounting may be part of this, see Campos, Jaimovich, and Panizza 2006)

19. Contribution to debt growth of extra-budgetary items (balance-sheet effects, skeletons, etc.) Simple average for: Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela

20. The Case for Discretion Procyclicality might be less important than previously thought –Reverse causality: fiscal expansion causes a boom (and not vice versa), see Rigobon, 2004, Jaimovich and Panizza, 2006)

21. Issues for Discussion Can CAB rules play a useful role or do they impose unnecessary constraints? Can EMs confidently estimate trend and cyclical output? Is creative accounting an issue? Are independent fiscal councils a good idea? –To prepare non-forecast for revenues and growth –Can decision of the size of the budget balance be delegated to an independent authority?

22. Issues for Discussion Even if CAB rules can play a useful role, implementing such rules is the best way to spend scarce political capital? Is the sequencing important? Should more modest budget reforms (transparency, hierarchical rules, FRL) come first?