Why do so many countries so often wander far off the path of fiscal responsibility? Concern about budget deficits has become a burning political issue in the United States, has helped persuade the United Kingdom to enact stringent cuts despite a weak economy, and is the proximate cause of the Greek sovereign-debt crisis, which has grown to engulf the entire eurozone. Indeed, among industrialized countries, hardly a one is immune from fiscal woes.

Clearly, part of the blame lies with voters who don’t want to hear that budget discipline means cutting programs that matter to them, and with politicians who tell voters only what they want to hear. But another factor has attracted insufficient notice: systematically over-optimistic official forecasts.

Such forecasts underlie governments’ failure to take advantage of boom periods to strengthen their finances, including running budget surpluses. During the expansion of 2001-2007, for example, the US government made optimistic budget forecasts at each stage.  These forecasts supported enacting big long-term tax cuts and accelerating growth in spending (both military and domestic).  European countries behaved similarly, running up ever-higher debts.  Predictably, when global recession hit in 2008, most countries had little or no “fiscal space” to implement countercyclical policy.

In most cases, the problems have long been plain for objective observers to see, but public officials kept their heads buried in the sand.  Over the period 1986-2009, the bias in official U.S. deficit forecasts averaged 0.4 % of GDP at the one-year horizon, 1% at two years, and 3.1% at three years.  Forecasting errors were particularly damaging during the past decade.  The U.S. government in 2001-03, for example, was able to enact large tax cuts and accelerated spending measures by forecasting that budget surpluses would remain strong.   The Office of Management and Budget long turned out optimistic budget forecasts, no matter how many times it was proven wrong.   For eight years, it never stopped forecasting that the budget would return to surplus by 2011, even though virtually every independent forecast showed that deficits would continue into the new decade unabated.

How were American officials in the last decade able to make forecasts that departed so far from subsequent reality?   In three sorts of ways.  The first comes in the form of optimistic baseline macroeconomic assumptions such as a high and everlasting growth rate.  OMB forecasts of economic growth were biased upward:  by a huge 3.8% at the three-year horizon.

Second, some politicians argued that tax cuts were consistent with fiscal discipline by appealing to two fanciful theories:   the Laffer Proposition, which says that cuts in tax rates will pay for themselves via higher economic activity, and the Starve the Beast Hypothesis, which says that tax cuts will increase the budget deficit but that this will put downward pressure on federal spending. 

Sanguine macroeconomic assumptions will do the job in the context of OMB forecasts and fanciful theories about the effects of tax cuts can deliver the rosy scenarios of presidential speeches.  But to get optimistic fiscal forecasts out of the Congressional Budget Office a third, more extreme, strategy was required.  (In 2003, when some Lafferite congressmen tried to get CBO to say that “dynamic scoring” of the effects of  tax rate cuts would show higher revenue, the estimates from the independent agency did not give the answer they wanted.) 

To understand the third strategy, begin with the requirement that CBO’s baseline forecasts must take their tax and spending assumptions from current law.   Elected officials in the last decade therefore hard-wired over-optimistic budget forecasts from CBO by excising from current law expensive policies that they had every intention of pursuing in the future.  Often they were explicit about the difference between their intended future policies and the legislation that they wrote down. 

Four examples: (i) the continuation of wars in Afghanistan and Iraq (which were paid for with “supplemental” budget requests when the time came, as if they were an unpredictable surprise); (ii) annual revocation of purported cuts in payments to doctors that would have driven them out of Medicare if ever allowed to go into effect; (iii) annual patches for the Alternative Minimum Tax (which otherwise threatened to expose millions of middle class families to taxes that had never been intended to apply to them); and (iv) the intended extension in 2011 of the income tax cuts and estate tax abolition that were legislated in 2001 with a sunset provision for 2010, which most lawmakers knew would be difficult to sustain.    All four are examples of expensive policy measures that Congress fully intended would take place, but that it excluded from legislation so that the official forecasts would misleadingly appear to show smaller deficits and a return to surplus after 2010.

Unrealistic macroeconomic assumptions, fanciful theories about tax cuts, and legislation that deliberately misrepresented policy plans all worked as intended, yielding over-optimistic forecasts.  These in turn help to explain excessive budget deficits. In particular, they explain the failure to run surpluses during the economic expansion from 2002-2007: if growth is projected to last indefinitely, retrenchment is regarded as unnecessary.

Many have suggested that budget woes can best be held in check through fiscal-policy rules such as deficit or debt caps. Some countries have already enacted laws along these lines.  The most important and well-known example is the eurozone’s fiscal rules, which supposedly limit budget deficits to 3% of GDP and public debt to 60% of GDP for countries to join.  The European Union’s Stability and Growth Pact (SGP) dictated that member countries must continue to meet the criteria.   We have now seen how well that worked out.

Other countries have also adopted fiscal rules, most of which fail.  Switzerland’s structural budget rule (”debt brake”) is well-designed to allow higher deficits in recessions automatically, counterbalanced by surpluses in expansion periods. But the success of any budget rule depends on accurate forecasts of government spending and revenues. Getting those forecasts right has proven to be difficult for most countries.

Part of the problem is that governments that are subject to budget rules, such as Europe’s SGP, put out official forecasts that are even more biased than the US or other countries.  The Greek government, for example, in 2000 projected that its fiscal deficit would shrink below 2% of GDP one year in the future and below 1% of GDP two years into the future, and that the fiscal balance would swing to surplus three years into the future. The actual balance was a deficit of 4-5% of GDP - well above the EU’s 3%-of-GDP ceiling.

In almost all industrialized countries, official forecasts have an upward bias, which is stronger at longer horizons. On average, the gap between the projected budget balance and the realized balance among a set of 33 countries is 0.2% of GDP at the one-year horizon, 0.8 % at the two-year horizon, and 1.5 % at the three-year horizon.  So, how can governments’ tendency to satisfy fiscal targets by wishful thinking be overcome? In 2000, Chile created structural budget institutions that may have solved the problem. Independent expert panels, insulated from political pressures, are responsible for estimating the long-run trends that determine whether a given deficit is deemed structural or cyclical.

The result is that, unlike in most industrialized countries, Chile’s official forecasts of growth and fiscal performance have not been overly optimistic, even in booms. The ultimate demonstration of the success of the country’s fiscal institutions:  unlike many countries in the North, Chile took advantage of the 2002-2007 expansion to run substantial budget surpluses, which enabled it to loosen fiscal policy in the 2008-2009 recession. Perhaps other countries should follow its lead.

[A shorter version of this op-ed was published by Project Syndicate.   It draws on several recent academic publications of mine, especially "Over-optimism in Forecasts by Official Budget Agencies and Its Implications,"  Oxford Review of Economic Policy  27, no.4, 2011, 536-562.]  

Libyans have a new lease on life, a feeling that, at long last, they are the masters of their own fate. Perhaps Iraqis, after a decade of warfare, feel the same way. Both countries are oil producers, and there is widespread expectation among their citizens that that wealth will be a big advantage in rebuilding their societies.

Meanwhile, in Africa, Ghana has begun pumping oil for the first time, and Uganda is about to do so as well. Indeed, from West Africa to Mongolia, countries are experiencing windfalls from new sources of oil and mineral wealth. Adding to the euphoria are the historic highs that oil and mineral prices have reached on world markets over the last four years.

Many countries have been in this position before, exhilarated by natural-resource bonanzas, only to see the boom end in disappointment and the opportunity squandered with little payoff in terms of a better quality of life for their people. But, whether in Libya or Ghana, these countries’ current leaders have an advantage: most are well aware of history, and want to know how to avoid the infamous natural-resource “curse.”

To prescribe a cure, one must first diagnose the illness. Why do oil riches turn out to be a curse as often as they are a blessing?

Economists have identified six pitfalls that can afflict natural-resource exporters: commodity-price volatility, crowding out of manufacturing, “Dutch disease” (a booming export industry causes rapid currency appreciation , which undermines other exporters’ competitiveness), excessively rapid resource depletion, inhibition of institutional development, and civil war.

Oil prices are especially volatile, as the large swings over the last five years remind us. The recent oil boom could easily turn to bust, especially if global economic activity slows.

Volatility itself is costly, leaving economies unable to respond effectively to price signals. Temporary commodity booms typically pull workers, capital, and land away from fledgling manufacturing sectors and production of other internationally traded goods. This reallocation can damage long-term economic development if those sectors are the ones that nurture learning by doing and fuel broader productivity gains.

The problem is not just that workers, capital, and land are sucked into the booming commodity sector. They also are frequently lured away from manufacturing by booms in construction and other non-tradable goods and services. The pattern also includes an exuberant expansion of government spending, which can result in bloated public payrolls and large infrastructure projects, both of which are found to be unsustainable when oil prices fall. If the manufacturing sector has been “hollowed out” in the meantime, so much the worse.

Another pitfall is excessively rapid depletion of oil or mineral deposits, in violation of optimal rates of saving, let alone preservation of the environment.   

Even if high oil revenues turn out to be permanent, pitfalls nonetheless abound. Governments that can finance themselves simply by retaining physical control over the oil or mineral deposits located within their borders often fail in the long run to develop institutions that are conducive to economic development.  Such countries evolve a hierarchical authoritarian society where the only incentive is to compete for privileged access to commodity rents. In the extreme case, this competition can take the form of civil war. In a country without resource wealth, by contrast, elites have little alternative but to nurture a decentralized economy in which individuals have incentives to work and save. These are the economies that industrialize.

What can countries do to ensure that natural resources are a blessing rather than a curse?  Some policies and institutions have been tried and failed. These include, in particular, attempts to suppress artificially the fluctuations of the global marketplace by imposing price controls, export controls, marketing boards, and cartels.

But some countries have succeeded, and their strategies could be useful models for Libya, Iraq, Ghana, Mongolia, and others to emulate. These include: hedging export earnings - for example, via the oil options market, as Mexico does; ensuring countercyclical fiscal policy - for example via Chile’s kind of structural budget rule; and delegating sovereign wealth funds to professional managers, as Botswana’s Pula Fund does.

Finally, some promising ideas have virtually never been tried at all: linking bonds to oil prices instead of dollars, to protect against the risk of a price decline; choosing Product Price Targeting as an alternative to either inflation targeting or exchange-rate targeting, to play the role of anchor for monetary policy; and distributing oil revenues on a nationwide per capita basis, to ensure that they do not wind up in elites’ Swiss bank accounts.

Leaders have free will. Oil exporters need not be prisoners of a curse that has befallen others. Countries can choose to use their resource bonanzas for the long-term economic advancement of their peoples.

[This column originally appeared at Project Syndicate.  Comments can be posted there.]

[This column is co-authored with Carlos Végh and Guillermo Vuletin and was published in VoxEU.]

Everywhere one looks, problems of fiscal policy are now center stage.   Among advanced countries, the news is bad:   Europe’s periphery teeters, the U.K. slashes, the U.S. deadlocks, Japan muddles.  But in the rest of the world there is better news:   In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.

In the past, developing countries tended to follow procyclical fiscal policy:   they increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession.  Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialized countries that has been by and large countercyclical. (References for this proposition and others are available.)   Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle.  Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or even more than proportionately. One can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.

Figure I (which is a version of evidence presented in Kaminsky, Reinhart and Vegh, 2004) depicts the correlation between government spending and GDP for 94 countries over the period 1960-1999.   More precisely, it shows the correlation between the cyclical components of spending and GDP;  the longer term trends are taken out.   The set includes 21 developed countries, which are represented by black bars, and 73 developing countries, represented by yellow bars.  A positive correlation indicates government spending that is procyclical, that is, destabilizing.  A negative correlation indicates countercyclical spending, that is, stabilizing.  

[Click here for enlargement of Figure I.] 

There is no missing the message.  Yellow bars lie overwhelmingly on the right hand side:  more than 90 percent of developing countries show positive correlations (procyclical spending).  Black bars dominate the left hand side:  around 80 per cent of industrial countries show negative correlations (countercyclical spending).

 Over the last decade there has been a historic shift in the cyclical behavior of fiscal policy in the developing world.     Figure II updates the statistics, showing the period 2000-2009.  The number of yellow bars on the left side of the graph (negative correlations) has greatly increased.   Around 35 percent of developing countries [26 out of 73] now show a countercyclical fiscal policy, more than quadruple the share during the earlier period.  

[Click here for enlargement of Figure II.] 

Figure III presents a scatter plot with the 1960-1999 correlation on the horizontal axis and the 2000-2009 correlation on the vertical axis.  The lower right quadrant shows the graduates from procyclical to countercyclical fiscal policy.  The star performers include Chile and Botswana; but 24 developing countries altogether (out of 73) have made this historic shift.  

[Click here for enlargement of Figure III.] 

The evidence of countercyclicality among many emerging market and developing countries matches up with other criteria for judging maturity in the conduct of fiscal policy:    debt/GDP ratios, rankings by rating agencies, and sovereign spreads.  Low income and emerging market countries in the aggregate have achieved debt/GDP levels around 40 percent of GDP over the last four years.  [The IMF estimates the 2011 ratio at 43 per cent among emerging market countries and 35 per cent among low-income countries]. This is the same period during which debt in advanced countries has risen from about 70 per cent of GDP to 102 percent.   The financial markets have ratified the historic turnaround.   Spreads are now lower for many emerging markets than for some “advanced countries.”    Rating agencies rank Singapore as more creditworthy than Belgium, Korea ahead of Portugal, Mexico ahead of Iceland, and just about everybody ahead of Greece.    Euromoney ranks Chile as less risky than Japan, Korea less risky than Italy, Malaysia less risky than Spain, and Brazil less risky than Portugal.

Largely as a result of their improved fiscal situations during the period 2000-2007, many emerging markets were able to bounce back from the 2008-2009 global financial crisis more quickly than advanced countries.   

What explains the ability of some countries, particularly emerging market and developing countries, to escape the trap of procyclical fiscal policy? Many researchers have pointed to the importance of institutions.  In new research we find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality (which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment).    The relationship holds also when instrumental variables are used.

Although one thinks of institutions as slow-moving, they can change over time.   Chile’s institutional quality has risen strongly since the early 1980s, during which time its fiscal policy has turned from procyclical to countercyclical.   A country with good institutional quality in the general sense of rule of law can help lock in countercyclical fiscal policy through specific budget institutions.   Chile did it with the structural budget reforms of 2000 and 2006.   Chile’s approach could be emulated by others.

Fiscal rules, such as euroland’s  Stability and Growth Pact, may accomplish little in themselves.   Rules can actually worsen the tendency of governments to make overly optimistic forecasts for economic growth and budget balance.   Chile’s key innovation was to give responsibility for forecasting to independent expert commissions, insulated from politicians’ wishful thinking.

Even advanced countries have something to learn about countercyclical fiscal policy from Chile and others to the South.  Saving during expansions such as 2001-06 is critical for weathering the storm in recessions such as 2008-09.  Otherwise there may be no way out but to adjust at the worst possible time.

During much of the last decade, U.S. fiscal policy has been procyclical, that is, destabilizing.   We wasted the opportunity of the 2003-07 expansion by running large budget deficits.   As a result, in 2010, Washington now feels constrained by inherited debts to withdraw fiscal stimulus at a time when unemployment is still high.   Fiscal policy in the UK and other European countries has been even more destabilizing over the last decade.  Governments decide to expand when the economy is strong and then contract when it is weak, thereby exacerbating the business cycle.    

Meanwhile, some emerging market and developing countries have learned how to run countercyclical fiscal policy - saving in the boom and easing in the recession - during the same decade that we advanced countries have forgotten how to.    

The frenetic debate at any moment for or against “fiscal conservatism” is artificial.  It is not the right answer always to shrink any more than it is the right answer always to expand.  Americans should take a perspective longer than the annual budget cycle or the bi-annual electoral cycle, let alone the daily news cycle.   When the United States was able to take advantage of the long 1992-2000 boom to eliminate its budget deficit, the key legislation had been enacted in 1990 and 1993.   Similarly, the big deficits of the last ten years were created by the legislation of 2001 and 2003.   Bringing back far-sighted fiscal policy would mean taking steps today to lock in long-term progress toward fiscal responsibility (such as enacting social security reform) but at the same time extending last year’s short-term fiscal stimulus so long as the economy is still weak.

It might help to have ways to insulate fiscal policy from some of the wilder vagaries of politics.    I came away from a conference in Chile recently, impressed anew by that country’s accomplishments.  It has achieved countercyclical fiscal policy over the last ten years by means of some innovative institutions.   Chile has a rule that targets the structural budget balance.  In other words, it can only run a deficit to the extent that GDP and the price of copper are below their long-run trends.  But a structural budget rule is not enough in itself.   Who is to say which deficits are structural and which are temporary?  Chile’s key innovation ten years ago was to vest responsibility for determining the long-run trends in GDP and copper prices in two panels of independent experts.   Why does this matter?   One reason that politicians spend too much in booms is that they convince themselves that deficits are temporary even when they are really structural.  Officials in the US and Europe made overly-optimistic forecasts of future growth rates and tax revenues during the 2001-07 expansion.  Research shows that this is a systematic pattern.  The biased forecasts contributed to unaffordable tax cuts and accelerated spending, which in turn spelled excessive deficits and debts.  Today we are living with the consequences of this procyclicality.

Perhaps we should look South, in order to re-learn how to run countercyclical budgets. 

[For comments, go to SeekingAlpha.]

     Two decades ago, many thought the lesson of the 1980s had been that Japan’s variant of capitalism was the best model, that other countries around the world should and would follow it.   The Japanese model quickly lost its luster in the 1990s.  

     One decade ago, many thought that the lesson of the 1990s had been that the US variant of capitalism was the best model, that other countries should and would follow.   The American model in turn lost its attractiveness in the decade of the 2000s.   

     Where should countries look for a model, now, in 2010?  Many small countries on the periphery have experimented with policies and institutions that could usefully be adopted by others.  

     A panoply of innovations has helped Chile to outperform its South American neighbors.   Chile’s fiscal institutions - structural budget balance with the parameters estimated by independent expert panels — insure a countercyclical budget.  They are among the mechanisms that are particularly worthy of emulation by other commodity exporting countries, to defeat the Natural Resource Curse.  

     Costa Rica in Central America and Mauritius in Africa each pulled ahead of its peers some time ago.  Among many other decisions that worked out well for them, both countries have foregone a standing army. The result in both cases has been histories with no coups, and financial savings that can be used for education, investment, and other good things.  Singapore achieved rich country status with a unique development strategy.  Among its many innovations were a paternalistic approach to saving and use of the price mechanism to defeat urban traffic congestion (now emulated by London). 

     Some small advanced countries also have lessons to offer.   New Zealand led the way with Inflation Targeting, along with many liberalization reforms in the late 1980s.   (Perhaps its Labor Party should even be given credit for pioneering the principle that left-of-center governments can sometimes achieve economic liberalization better than their right-of-center opponents.)   Ireland showed the importance of Foreign Direct Investment.  Estonia led the way in simplifying its tax system by means of a successful flat tax in 1994, followed by Slovakia and other small countries in Central/Eastern Europe and elsewhere (including Mauritius again).   

     Mexico pioneered the idea of Conditional Cash Transfers (the OPORTUNIDADES program — originally PROGRESA, launched in 1998).  CCT programs have subsequently been emulated by many developing countries.  This was two revolutions in one:  (1) the specific idea of making poverty transfers contingent on child school attendance (which has been emulated even in New York City) and (2) the methodological idea of conducting controlled experiments to find out what policies work or don’t work in developing countries (which has fed into the exciting Randomized Control Trials movement in development economics).  Also in the 1990s, largely thanks to the leadership of President Ernesto Zedillo, Mexico adopted non-partisan federal electoral institutions that were subsequently in 2006 able to resolve successfully a disputed election.   (In contrast, it turned out in November 2000 that the United States had no mechanism to resolve such disputes, other than the preferences of political appointees.)  Mexico undertook health reform in 2004.  More recently, President Felipe Calderon has shut down the entrenched electric utility and pursued much-needed reforms in tax, pension, and other areas.

     In highlighting some very specific institutions that could be usefully applied elsewhere, I don’t mean to suggest that they can be effortlessly translated from one national context to another.   Nor do I mean to suggest that these examples are entirely responsible for the success of the economies identified.  (Indeed a few of these countries have recently been wrestling with severe problems.)  But a country doesn’t have to be large like the United States to serve as a model for others.  Small countries tend to be trade-dependent, and open to new ideas.  They are often more free to experiment than are large countries. The results of the experiments include some useful lessons.

[TV interview on BNN.]

            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?  

   (more…)