Does the level of industrialisation affect a country’s fiscal policy?

From a theoretical point of view, procyclical fiscal policies remain a puzzle. In neoclassical models, the optimal fiscal policy stance is either a-cyclical (Barro 1979) or counter-cyclical (Baxter and King 1993). In Keynesian models, on the other hand, with the presence of sticky prices or wages, the optimal fiscal policy stance is counter-cyclical (Christiano et al. 2011, Nakata 2013). And from a risk management point of view, a countercyclical fiscal policy can be useful for at least three compelling reasons (see World Bank 2014):

First, by leaning against the wind, governments can continue to provide goods and services and to maintain public investment even in the event of a drop in public revenues;
Second, in a downturn, a countercyclical fiscal policy can help governments increase social assistance and insurance to a large number of citizens affected by more adverse macroeconomic conditions;
Third – as we witnessed during the global financial crisis of 2008-09 – a countercyclical fiscal policy can help countries stimulate the economy and cope better with the effects of a prolonged recession. It has been argued that, in the last 6 years, the underutilisation of counter-cyclical fiscal policies in crisis-ridden advanced economies has been partly responsible for their sluggish post-crisis recovery (Canuto 2014).

Are fiscal policies predominantly procyclical in developing countries?

A significant number of authors have documented the more procyclical behaviour of fiscal policy in developing countries. Industrialised countries, in turn, tend to behave largely in a counter-cyclical or, at worst, a-cyclical fashion – except for the more recent precocious adoption of fiscal adjustment in particular countries. An idea put forward by Kaminsky et al. (2004) was that for developing countries (especially upper middle-income countries), macroeconomic policies and especially fiscal policy tend to reinforce the business cycle (the ‘when-it-rains-it-pours’ syndrome).

Evidence on the procyclical pattern of fiscal policy in developing countries was first found by Gavin and Perotti (1997), who showed that Latin American was much more expansionary in good times and contractionary in bad times. Talvi and Vegh (2000) then showed that such behaviour was far from being a trademark of Latin America alone as many other developing countries across the world espoused a procyclical fiscal policy stance. There are a number of different explanations as to why developing countries tend to behave in this way vis à vis industrialised economies. Some of the reasons most commonly found in the literature include credit constraints faced by developing countries, which would prevent them from raising money in international capital markets in bad times and would force them to adopt a contractionary fiscal policy in downturns (Gavin and Perotti 1997). Political economy considerations would also seem to play a role as good times could encourage fiscal profligacy (Tornell and Lane 1999, Alesina and Tabellini 2005).

On the other hand, Frankel et al. (2013) have suggested a recent change of pattern, with many emerging market economies ‘graduating’ out of procyclical fiscal policy. Using a proxy for fiscal cyclicality based on a time series of real government expenditures smoothed by the Hodrick-Prescott filter, the authors were able to classify the countries according to their ‘ability to graduate’ from fiscal procyclicality. A negative (positive) correlation coefficient between the cyclical component of government spending and GDP indicates a counter-cyclical (procyclical) fiscal policy stance. Countries with negative coefficients in two subsequent periods (1960-1999 against 2000-2009) were classified as established graduates, for example, as opposed to countries with positive coefficients in both sub-periods which were classified as ‘still in school’.

When it rains in emerging markets, does it really pour?

Two of us (Carneiro and Garrido 2015) have recently re-addressed this empirical question.1 Two implicit assumptions are made as to why countries change their fiscal stance:

• First, countries generally consider changes as non-random;

That is, changes are mostly associated with policy shifts within given administrations – which may or may not be politically motivated (as incumbent administrations tend to spend more ahead of elections) – or across administrations after elections (that is, policy shifts are influenced by ideological principles).

• Second, countries assume that changes are generally driven or motivated by observed trends in economic activity and not the other way around (e.g. Kaminsky et al. 2004).

This assumption is not uncontroversial. For instance, Rigobon (2004) argues that fiscal policy shocks drive output and not the other way around, while Ilzetzki and Vegh (2008) find causality running both ways.

Keeping these assumptions in mind, the study re-computed correlation coefficients for the fiscal cyclicality proxy for the period 1990-2011 by differentiating what happens in fiscal policy in different parts of the business cycle. It may be the case that a country’s average fiscal stance within a period differs during years of expansion compared to that adopted in years of downturn in economic activity. Countries that are, on average, procyclical in booms and downturns, would tend to exacerbate their business cycle. Those that are counter-cyclical in both, booms and downturns have a fiscal policy that contributes to stabilising the cycle.

But countries may not always be procyclical or counter-cyclical. Whenever a country exhibits an average counter-cyclical fiscal stance in booms, and a procyclical stance in downturns, other things equal, it will likely improve its medium- to long-term fiscal sustainability profile. A country that is procyclical in booms and counter-cyclical in downturns would, all else being equal, deteriorate its fiscal sustainability profile.

Figure 1 plots the value of the fiscal stance proxy in periods of expansion (when the cyclical component of real GDP are positive) versus that registered in downturns. High-income countries are those in red while developing economies are in blue.2 We identify four groups of countries and split them into four quadrants:

• Upper right quadrant – those that exhibit procyclical fiscal policies in both booms and downturns;

Other things equal, such a stance contributes to exacerbating output volatility. Not surprisingly, we find many resource-rich economies in this category. In addition, many upper middle-income countries appear in this group.

• Upper left quadrant – those that exhibit counter-cyclical fiscal policies in booms and procyclical fiscal policies in downturns;

Other things equal, such fiscal behaviour improves a country’s fiscal sustainability profile.

• Lower left quadrant – those that exhibit counter-cyclical fiscal policies in both booms and downturns;

Other things being equal, such a stance contributes to stabilising output around its long-term trend. Expectedly, most high-income countries fall into this category.

• Lower right quadrant – those that exhibit procyclical fiscal policies in booms and counter-cyclical fiscal policies in downturns. Other things being equal, such behaviour deteriorates a country’s fiscal sustainability profile.

A simple visual inspection of Figure 1 seems to lend partial support to the ‘when-it-rains-it-pours’ phenomenon. Most of the countries in the upper and lower right quadrants of the chart are developing economies (in blue) and, most importantly, upper middle-income countries. In contrast to that, most of the high income countries appear on the upper and lower left quadrants with fiscal stances that largely contribute to long-term fiscal sustainability. However, it also confirms earlier findings in the literature showing that a number of developing countries have graduated from fiscal policy procyclicality (see Frankel et al. 2013).

Figure 1. Fiscal cyclicality in booms and downturns (1990-2011)

Source: Carneiro and Garrido (2015).

The good, the bad and the ugly

Some of the results in Figure 1 may seem counter-intuitive but they actually uncover the good, the bad and the ugly.

For instance, one may be surprised to see Chile, a country that has earned a reputation of fiscal prudency and good overall macro management, in the fourth quadrant. As it turns out, Chile is, on average, for the period 1990-2011, moderately procyclical in booms and markedly anti-cyclical in downturns. Its ability to sustain a strong fiscal position arises from having a system of buoyant tax revenues and the great contribution of the private sector to economic activity, so the country is able to register solid, positive fiscal balances both in booms and recessions with marked improvements in its overall fiscal stance.

Chile remains pretty much among the good guys. Compare this performance with that of Greece, for example, especially during the post-financial crisis period when it showed deteriorating fiscal balances, faster increases in expenditures relative to revenues, and poor economic performance, with an exacerbated contribution to volatility derived from a more procyclical fiscal stance. With this, there is no doubt that Greece has yet to earn enough stars to join Chile’s quadrant.

And what about the ugly? As it turns out, many resource-rich countries remain clustered in the bottom right-hand quadrant. This is where things get too ugly too quickly. For this group of countries, in good times, all is well that ends well, but as soon as things turn sour so does their governments’ ability to lean against the wind.

Carneiro and Garrido (2015) have also confirmed that institutional quality is an important determinant of a country’s fiscal stance. This is an important result that suggests that efforts to graduate from fiscal policy procyclicality need to be accompanied by policy reforms that seek to strengthen the ability of countries to save in good times to generate fiscal buffers that could be used in bad times. Initiatives such as the establishment of fiscal councils and the adoption of fiscal rules, the development of sound debt management strategies that reinforce fiscal discipline, and the strengthening of macro prudential regulations appear to be necessary conditions for graduating from procyclicality.

Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.

References

Alesina, A, and G Tabellini (2005), “Why is Fiscal Policy Often Procyclical?”, National Bureau of Economic Research Working Paper Series, Working Paper 11600.

Barro, R (1979), “On the Determination of Public Debt”, Journal of Political Economy 87: 940-971.

Baxter, M, and R King (1993), “Fiscal Policy in General Equilibrium”, The American Economy Review 83: 315-334.

Carneiro, F and L Garrido (2015), “New Evidence on the Cyclicality of Fiscal Policy”, The World Bank Policy Research Working Paper Series, Working Paper 7293.

Christiano, L, M Eichenbaum, and S Rebelo (2011), “When Is the Government Spending Multiplier Large?”, Journal of Political Economy 119: 78-121.

Canuto, O (2014), “Macroeconomics and Stagnation – Keynesian-Schumpeterian Wars”, Capital Finance International: 14-19, Spring.

Frankel, J A, C A Vegh and G Vuletin (2013), “On graduation from fiscal procyclicality”, Journal of Development Economics 100: 32-47.

Gavin, M, and R Perotti (1997), “Fiscal Policy in Latin America”, National Bureau of Economic Research.

Ilzetzki, E, and C A Vegh, (2008), “Procyclical Fiscal Policy in Developing Countries: Truth or Fiction?”, NBER Working Paper Series, Working Paper 14191.

Kaminsky, G L, C M Reinhart,  C A Végh (2004), “When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies”, NBER Working Paper Series, Working Paper 10780.

Nakata, T (2013), “Optimal Fiscal and Monetary Policy with Occasionally Binding Zero Bound Constraints”, Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board.

Rigobon, R (2004), comments on “When It Rains It Pours: Pro-cyclical Capital Flows and Macroeconomic Policies”, in M Gertler K Rogoff (eds.) NBER Macroeconomics Annual, MIT Press.

Talvi, E and C A Vegh (2000), “Tax Base Variability and Procyclical Fiscal Policy”, NBER Working Paper Series, Working Paper 7499.

Tornell, A and P R Lane (1998), “The Voracity Effect”, The American Economic Review 89: 22-46.

World Bank (2014), “Risk and Opportunity: Managing Risk For Development”. World Development Report 2014, Washington, DC.

Footnotes

1 We report here the results based on an extended sample that includes 180 countries, of which 134 are developing countries and 46 are high income, over the period 1980-2012.

2 This is a World Bank classification. The sample includes 156 countries after dropping countries with less than five observations available when the cyclical component of real GDP is more than zero or less than five observations available when the cyclical component of real GDP is less than zero.

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Otaviano Canuto is Senior Advisor on BRICS Economies in the Development Economics Department, World Bank. Francisco Carneiro is the Lead Economist and Program Leader for the Caribbean at the World Bank. Leonardo Garrido is an independent Research Consultant for the World Bank and other development organizations.

Image: A man walks past buildings at the central business district of Singapore. REUTERS/Nicky Loh.