Chile’s Countercyclical Triumph

Though politicians love to talk about saving for a rainy day, not many have actually managed to pull it off. How Chile bucked the trend.


The news from Chile these days is dominated by the sagging popularity of conservative President Sebastian Piñera. But just four years ago, Chile was equally turned off by Piñera left-center predecessor, Michele Bachelet (above) — though for completely different reasons.

Bachelet’s low approval ratings in 2008 were largely due to her refusal to spend soaring government receipts from copper exports. The world price of copper — Chile’s largest export — hit $800 per metric ton that year, an historic high in nominal terms and more than quadruple the level of 2001. Yet her government insisted on saving most of the proceeds for a rainy day.

What a difference a few years could make: By the time they completed their term in early 2010, Bachelet and her finance minister, Andrés Velasco, enjoyed the highest approval ratings of any president and cabinet minister since the return of democracy to Chile.

That reversal can’t be attributed to the fortunes of the Chilean economy. Quite the contrary: At the time, Chile was bearing the brunt of the global recession. In 2009, the price of copper fell abruptly, growth turned negative, and unemployment topped 10 percent. But the government was able to respond with sharply increased spending to cushion the blow and speed the recovery, drawing down revenues that had accumulated while the world couldn’t get enough Chilean copper. Now that the rainy day had come, Bachelet and Velasco were viewed as heroes.

The significance of this episode is not that an especially wise or brave policy prescription can make a very big difference; it can, but the idea of saving in a boom in order to be able to spend in the bust is not new. And while action to this end is less common than the words, there are certainly examples of governments that have shown the courage to put away the fiscal punch bowl before the crowd had drunk its fill.

What the world needs — and, ironically, what was delivered by Chile rather than by a mature industrialized economy — is institutions designed to produce good policies even when the officials charged with carrying them out are vulnerable to wishful thinking or inclined toward expediency. Indeed, Chile’s handling of the copper-price roller coaster could serve as a template for other countries in which the political pressures to follow "pro-cyclical" fiscal policies are very hard to resist.

The restraint on Chile’s fiscal policy is codified in law. The government must announce a budget target — originally set at a surplus of one percent of GDP, but softened to zero (i.e., budget balance) in 2009. That sounds a lot like the eurozone’s Stability and Growth Pact, which was supposed to limit member-states’ deficits to three percent of GDP. But unlike Chile’s budget rule, the SGP was born to fail. As everyone knows by now, the fiscal limits were repeatedly violated by members large and small.

The flaw in the original SGP was its rigidity. It didn’t allow "countercyclical" fiscal policy — that is, policies that offset the changing tides of private demand. It did not even permit budget deficits to rise if the cause was declining tax revenues in recessions.

Chile’s rule beats the one-size-fits-all trap by targeting the structural budget deficit, defining the acceptable deficit by what it would have been in more normal times. In a boom, the government can thus spend the increased revenues if and only if the boom is structural — that is, permanent. If the bonanza is cyclical (and thus temporary), the revenues must be saved.

But there’s another flaw here, even with rules keyed to structural deficits: Who is to forecast economic growth? Who is to determine (in real time) what is structural and what is cyclical? Politicians can always attribute an excessive budget deficit to temporarily disappointing economic growth and duck the issue of reducing it — if they’re lucky, until they leave office.

Chile’s structural balance regime limits the loopholes by specifying that the government may run a deficit larger than the target only to the extent that output falls short of its long-run trend, or the price of copper is below its medium-term (10-year) equilibrium. And crucially, those numbers are not left to politicians to calculate. In the middle of each year, panels of independent experts estimate them. The government then follows prescribed procedures to translate the numbers into the structural budget balance.

I’ve studied official government forecasts of economic growth rates and budgets in 33 countries. On average, there is a significant bias toward optimism, which is stronger during economic upswings: growth apparently leads officials to conclude that good times will go on rolling indefinitely. This finding explains why so many governments fail to repair the holes in their roofs while the sun is shining.

More surprisingly in light of economists’ love affair with rules, the bias toward smiley faces is stronger for countries that have SGP-type rules than for those that do not. When a country’s budget deficit exceeds the rigid target, officials find it expedient to forecast that things will get better next year.

Nobody in Chile claims that the forecasts of experts are accurate. But they are far less likely to be systematically biased than those cooked up by politicians. Indeed, unlike the rest of the 33 countries, Chile has managed to produce forecasts that have not been biased toward optimism since 2000.

Part of the credit for Chile’s structural budget rule should go to the government of President Ricardo Lagos (2000-2006) and his finance minister, Nicolas Eyzaguirre. They opted for the structural budget benchmark, and delegated the calculations to experts. The payoff, in the form of budget surpluses in good times, was immediate. Between 2000 and 2005, public savings — that is, the difference between revenues and expenditures rose from 2.5 percent of GDP to 7.9 percent.

But in this first phase, the budget rule was not a formal mandate, and thus might well have been violated in a crunch. The newly elected Bachelet government enshrined the general framework in law in 2006. Global credit markets got the message: In December of that year, Chile was awarded a sovereign debt rating of A, several notches ahead of Mexico, Brazil, and other Latin American peers.

The copper boom provided the real test of the Bachelet administration’s determination to play by the rules. Bachelet was pressed hard to declare that the increase in the price of copper was permanent, thereby justifying increased spending in good times. But the expert panel ruled that most of the price increase was temporary, so most of the earnings had to be saved. And to its credit, the government supported the finding.

As a result, the fiscal surplus reached almost nine percent of GDP during the boom. Chile used the surplus to pay down its debt to a mere four percent of GDP and was still able to sock away a sum equal to about 12 percent of GDP in its sovereign wealth fund. The country’s credit rating climbed to A+, the same as Japan’s.

Which brings us back to the beginning of our story: The rainy-day fund was there to be spent in the recession of 2008-09, when stimulus was sorely needed. In short, Chile managed what policymakers in most developing countries have only dreamed about: A truly countercyclical fiscal policy.

There’s no compelling reason why a version of Chile’s structural budgeting institutions couldn’t be emulated by other developing countries that are dependent on the vagaries of commodity prices. The whole point, after all, is to design a system to work in an environment in which politicians are as prone to myopia as teenagers.

The Chilean approach could be improved even further by making it illegal to fire members of the expert panels. It is also worth thinking about making the structurally adjusted targets actively (as opposed to passively) countercyclical. Bachelet and Velasco were able to save more than required in the 2007-08 boom, allowing them to run a bigger deficit than the law required in the 2009 recession. Why not try to build that more aggressive approach into the budgeting formula?

While we’re at it, why limit the Chilean approach to developing countries? Last time I looked, budget discipline comes easy exactly nowhere.

<p> Jeffrey Frankel, a former member of President Clinton's Council of Economic Advisors, is the Harpel Professor of Capital Formation and Growth at Harvard University. </p>