Fiscal Rule for Normal and Difficult Times

International Monetary Fund. Western Hemisphere Dept.
Felipe Larraín, Luca Ricci, Klaus Schmidt-Hebbel, Hermann González, Metodij Hadzi-Vaskov, and Andrés Pérez
Published Date:
October 2019
  • ShareShare
Show Summary Details

Vittorio Corbo is currently President at Vittorio Corbo & Associates and has a distinguished career in academia, international financial institutions, and both the public and private sectors. In academia he has held posts at Pontifica Universidad Católica de Chile, Stanford University, Georgetown University, and Concordia University. He was Governor of the Central Bank of Chile between 2003–07 and has been a member of several high-level advisory bodies. Mr. Corbo has also been a board member to several important firms. Mr. Corbo has a bachelor’s degree in business administration from Universidad de Chile and a PhD in economics from MIT.

During the last 25 years, Chile has made substantial progress in the area of macroeconomic stability as a result of its institutional development and its policies. Macroeconomic stability has been supported by a monetary policy aimed at achieving low and stable inflation, managed by an independent central bank; fiscal policy that supports fiscal solvency and stability, governed by a fiscal rule; and appropriate financial regulation and supervision.

The components of this set of policies and institutions have worked together to generate stability, to establish a more favorable framework for entrepreneurial activity and investment, and, along with micro-reforms that include a successful integration to the world economy, have enabled Chile to achieve a long period of high growth, and as a result, has been able to make a substantial jump in its per-capita GDP over time.

The macro effects of the major international financial crisis of 2007–2008 were managed with counter-cyclical monetary policy and a temporary suspension of the fiscal rule. This experience prompted the need to strengthen the fiscal rule by introducing policies designed to manage shocks without affecting fiscal solvency. More recently, the fiscal accounts have deteriorated, as a result, inter alia, of the more relaxed objectives of the cyclically-adjusted balance (BCA) targets and spending pressures. Below, we shall suggest some approaches for the treatment of fiscal policy under normal conditions and in difficult times.

When only minor shocks are present in the economy, the use of the BCA as a target promotes macroeconomic stability. In such cases, monetary policy is the most efficient counter-cyclical macroeconomic policy approach. The macro role of fiscal policy should be to serve as an adjunct to monetary policy working as an acyclical rule, thereby ensuring fiscal solvency. The rule must be determined on an ex-ante basis and implemented on an ex-post basis. However, as the rule is acyclical, there are circumstances in which large domestic or external shocks could result in pronounced changes in domestic demand where the countercyclical role of monetary policy is not enough. In those cases it may be required to complement counter-cyclical monetary policy with counter-cyclical fiscal policy.

In fact, this approach was used in Chile in 2008 to address the effects on domestic demand of the great international financial crisis. In such cases, the important matter is to establish a clear policy on the mechanisms for returning to the rule once the emergency has ended so as to avoid an adverse impact on fiscal solvency over time.

Counter-cyclical fiscal policy can be achieved through a temporary change in the target on an ex-ante basis, or with escape clauses. The latter must be regulated and monitored by an autonomous body, and might be contingent, for example, on the size of the output gap. The autonomous body, that in this case could be the Autonomous Fiscal Council (CFA), would be required to express its independent opinion in a report to Congress justifying the suspension of the rule.

There may also be pronounced adjustments in fiscal expenditure for domestic reasons, deriving from sudden changes in the estimation of trend variables, and particularly long-term copper prices. These changes affect macroeconomic equilibria and relative prices, and therefore any error in their estimation can ultimately be costly. On the other hand, fiscal solvency may be affected by various issues of noncompliance or errors in the estimation of the fiscal rule. First of all, there are cases where effective GDP growth is below the potential level and the price of copper is below the trend level on a persistent basis, resulting in a stream of effective fiscal deficits and debt accumulation. Second, fiscal solvency may be affected by a very relaxed cyclically-adjusted balance target, for example, if the target is set as negative for a number of years. Last, if the BCA target is equal to zero, overestimating the structural parameters used to estimate the cyclically adjusted level of government revenues would lead to ex-post deficits. Structural parameters are difficult to estimate. More specifically, the more complex parameters include total factor productivity and long-term copper prices. However, to maintain fiscal solvency, effective fiscal debt must be monitored, and the cyclically-adjusted balance must be calibrated, in addition to the presence of an autonomous oversight body such as the Autonomous Fiscal Council.

Recent episodes that illustrate these points are noteworthy. During the 2008 crisis, the central bank lowered the policy rate all the way to 0.5 percent and the BCA was moved 2 percentage points of GDP below its target, with the “implicit” use of the escape clause. However, in 2010, the country sustained the shock of the earthquake, and then in 2015, the supercycle of copper prices that had been observed since 2012 began to fade. These factors, along with less stringent cyclically-adjusted balance targets, led to a slow normalization of fiscal policy and expenditure pressure, creating strains in the government balance sheet in recent years, and resulting in a deterioration of the fiscal accounts.

To restore fiscal credibility, sustainability must be incorporated more explicitly, with annual objectives, and the structural parameters must be more effectively estimated. One alternative is to place a limit on the stock of government debt while defining a target that includes a buffer to allow the level of debt to increase above the target in the presence of exchange rate or interest rate shocks at the international level.

    Other Resources Citing This Publication