Abstract
This paper analyzes the fiscal and monetary policy responses to crises in Latin America over the last 40 years. We argue that, on average, Latin American countries have “graduated” in terms of their policy responses in the sense that they have been able to switch from procyclical to counteryclical policy responses. This average response, however, masks a great deal of heterogeneity with some countries (such as Chile, Brazil, and Mexico) leading the graduation process and others (like Argentina and Venezuela) still showing procyclical policy responses. We further argue that countercyclical policy responses have been effective in reducing the duration and intensity of crises. Finally, we relate our analysis to the current crisis in the Eurozone and argue that, like in many instances in Latin America, procyclical fiscal policy has aggravated the duration and intensity of the crisis.
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Notes
As First Deputy Managing Director of the IMF (from September 1994 to August 2001), Stan was, of course, an astute observer of, and critical protagonist in, many of these crises (in particular, the Tequila crisis that started in December 1994, the Asian crises of 1997–98, and the Argentinean debacle that culminated in the December 2001 default). Through many speeches and lectures, Stan left us with a wealth of insights and policy lessons that future policymakers will only ignore at their peril.
In addition to Marichal (1989), see Calvo (1986), Calvo and Vegh (1999), Corbo and de Melo (1987), Corbo, de Melo, and Tybout (1986), Diaz-Alejandro (1984, 1985), Dornbusch and Edwards (1991), Fischer (1995), Galiani, Heymann, and Tommasi (2002), Hanson and de Melo (1983), Mussa (2002), and Reinhart and Rogoff (2009).
We should note that we will focus only on fiscal and monetary policy. We are therefore abstracting from other, potentially important, policy tools such as reserve requirements. In Federico, Vegh, and Vuletin (2012), we show how developing countries (and Latin American countries in particular) have actively used reserve requirements for macrostabilization purposes.
As will become clear, quarterly data is essential for our purposes because we wish to characterize monetary/fiscal policy often during relatively narrow windows. This has imposed some limitations in terms of available data.
This is the result of an unweighted average across countries. A similar picture emerges if one calculates a weighted average (for example, using the share of each country’s GDP in the region), given the relatively importance of Brazil and Mexico.
See Section “Data definition and sources” in Appendix for sources of all the data used in the analysis.
Appendix Section “Chronology of Crises” lists and characterizes each crisis in detail. In particular, it identifies the crisis period, the duration and intensity of the crisis, and, for later purposes, describes the context in which each GDP crisis occurred, paying particular attention to the role of external vs. domestic factors as determinant or triggering factors. The appendix also identifies the shape of the GDP crisis (W, L, U, or V shaped), the most prevalent exchange rate regime, and, based on Reinhart and Rogoff (2009), other type of crises (debt, currency, inflation, banking, and stock market) that may have occurred at the same time. Regarding the exchange rate regime, in most cases the exchange rate had some flexibility (in 56 percent of the cases, compared with 35 percent with crawling bands and 9 percent with fixed exchange rates).
Although admittedly arbitrary, the choice of 1998 seemed a natural one. First—and as discussed in Frankel, Vegh, and Vuletin (2013)—the late 1990s appears to have been a period where one can detect (through formal regressions using institutional quality as an explanatory variable) a marked improvement in macroeconomic policy. Within this period, 1998 seemed a natural candidate because no crisis took place in that year providing us with a clean break in the series. We also wanted to leave a reasonably large window (15 years in this case) where one can observe the “after” effects. If we modify our before-after date slightly (for example, 1997 or 2000) our main results are not affected.
For the time being, we will refer to them as “responses” implying, of course, that the causality has run from the GDP crises to fiscal/monetary policy and not vice versa. We will come back to these issues of causality below.
The cyclical components have been estimated using the Hodrick-Prescott filter.
Notice that for government spending, a positive (negative) correlation indicates procyclical (countercyclical) spending policy, whereas for the tax index, a negative (positive) correlation indicates procyclical (countercyclical) tax policy.
In fact, Mexico and Chile formally became members of the OECD in 1994 and 2010, respectively.
We should note that Colombia did not have crises before 1998 and we do not have data for Venezuela before 1998.
Notice that in this case a positive (negative) correlation indicates a countercyclical (procyclical) policy response.
Conceptually, any standard open economy model with imperfect asset substitution would allow monetary authorities to use interest rates as a policy instrument, even under predetermined exchange rates (see, for instance, Lahiri and Vegh (2003) and Flood and Jeanne (2005)). Needless to say—and although we do not explicitly incorporate it into our analysis of policy responses—the exchange rate regime has typically been a critical dimension of the overall macroeconomic policy framework, as emphasized in many pieces by Stan Fischer himself (see, for instance, his 1986 and 2001 contributions). Having said that, and as mentioned in Section I, in most cases the de facto arrangement during the crisis period had some flexibility.
Chile is the most prominent case, with the Central Bank lowering the monetary policy rate by 775 basis points from 8.25 percent in December 2008 to 0.5 percent in July 2009.
One may argue that the post-1998 countercyclical monetary policies may be heavily influenced by the post-2008 period, particularly if one thought that countries have been able to pursue aggressive countercyclical monetary policies not because countries have improved fundamentals or shifted policy, but rather because reduced rates in advanced economies allowed emerging markets to also cut policy rates without generating large depreciations. Our results do not seem to be driven by this possibility because if we calculate the cyclicality of monetary policy using the difference between the country policy rate and the U.S. Treasury bill rate, our main results remain valid. We should also note that, as follows from Appendix Section “Chronology of Crises,” 10 of the 18 post-1998 crises are not related to the global financial crisis.
In fact, both papers show that countercyclical fiscal policy is even more powerful when monetary policy has hit the zero lower bound, though this is naturally much less relevant for emerging countries.
Naturally, this approach does not allow us to account for omitted variables that might be correlated with fiscal and monetary policy.
Having said that—and just for the sake of exposition—we will discuss some of the results in terms of policies causing outcomes but, again, formally the issue of endogeneity is addressed below.
Our finding that countercyclical fiscal policy has helped in reducing the duration and intensity of GDP crises is, of course, related to the issue of how big are fiscal multipliers; see, for instance, Auerbach and Gorodnichenko (2011) and the references therein. In fact, Auerbach and Gorodnichenko (2011) argue that multipliers are larger in bad times than in good times. Riera-Crichton, Vegh, and Vuletin (2012) further suggest that it may matter whether government spending is going up or down and show that, at least for OECD countries, fiscal multipliers are even bigger in bad times when government spending is actually increasing.
Rigobon (2004) and Jaimovich and Panizza (2007) have argued that reverse causality may be responsible for the now standard finding in developing countries that fiscal policy has been procyclical. Ilzetzki and Vegh (2008), however, use several econometric methodologies to establish that there is indeed causality from the cycle to fiscal policy.
The three most common instruments are (i) a trade-weighted average of trade partners’ GDP; (ii) some measure of terms of trade; and (iii) the real rate on U.S. treasury bills.
A few crises, like Peru 2000–01 and Venezuela 2002–04, were caused by domestic political factors which, for our purposes, are still exogenous to monetary/fiscal policy.
Conceptually, this approach is very much in the spirit of Ortiz and others (2009) who focus on episodes of “systemic sudden stops” as a way of ensuring “exogeneity” of the policy responses.
As a very simple illustration, if we assume that the probability that a country is in crisis for domestic reasons is, say, 50 percent (and domestic-induced crises are independent events), the probability that all eight countries would be in crisis simultaneously is 0.4 percent (that is, less than 1 percent).
The 1980s debt crisis was the fifth (and most recent) major debt crisis in almost 200 years of Latin American history. As Marichal (1989) describes in masterful detail, major debt crises took place in 1826–28 (shortly after independence), 1873, 1980, and 1931. Every one of these major debt crises was preceded by heavy borrowing from industrial countries in a context of abundant global liquidity.
See, for example, Calomiris (1999), Galiani, Heymann, and Tommasi (2002), and Appendix Section “Chronology of Crises” on Brazil 1995 crisis, based on De Carvaho and Pirez de Souza (2011).
In fact, the Brazilian crisis of January 1999 (when the peg to the dollar was abandoned and the domestic currency allowed to float) is often partly attributed to the Asian and Russian financial crises, which forced Brazil to raise interest rates to defend the currency and cut fiscal spending to maintain credibility and prevent further capital outflows; see, for instance, Federal Reserve Bank of Dallas (1999) and the Brazilian 1998–99 crisis in Table A1, based on De Carvaho and Pirez de Souza (2011). In turn, the collapse of Brazil’s exchange rate policy was an important factor in Argentina’s 1999–2001 recession, which precipitated the December 2001 crisis (see Mussa, 2002).
The correlation of our synchronicity index with capital flows to this region is −0.58 (and significant at the 1 percent level). We should note that there is a large literature on the role of external factors in accounting for capital flows into Latin America. For example, both Calvo, Leiderman, and Reinhart (1993) and Izquierdo, Romero, and Talvi (2008), conclude that around 50 percent of the flows can be accounted for by external factors. This is fully consistent with our main storyline that external factors have accounted for an important fraction, though certainly not all, of crises in Latin America.
Needless to say, some of our eight countries are major commodity producers (two prime examples would be oil in the case of Venezuela and copper in the case of Chile) and their behavior could influence world prices but the effect on a global commodity price index is likely to be minor, if any.
In other words, there is no reason to expect variables such as, say, the current account deficit or debt to GDP ratio in time t−1 to have a direct effect on GDP at time t. For this reason, and as will become clear below, we have chosen variables that are, in principle, backward-looking.
We pool together data for Latin American and Eurozone countries to facilitate cross-country comparisons. The only exception in which the lower bound (that is, worst scenario) of the normalization is carried out at the regional level is for total (public plus private) external debt as percentage of GDP. For this variable, values for some European countries (such as Ireland in recent times) is close to 1,000 percent of GDP, while the highest value for Latin American economies is about 50 percent of GDP.
The need to defend the domestic currency in bad times is best exemplified by IMF advice during the 1997 Asian crisis. To quote Stanley Fischer himself (at the time the IMF’s First Deputy Managing Director) from a 1998 lecture, [i]n weighing [the question of whether programs were too tough], it is important to recall that when they approached the IMF, the reserves of Thailand and Korea were perilously low, and the Indonesian rupiah was excessively depreciated. Thus, the first order of business was, and still is, to restore confidence in the currency. To achieve this, countries have to make it more attractive to hold domestic currency, which, in turn, requires increasing interest rates temporarily, even if higher interest costs complicate the situation of weak banks and corporations. This is a key lesson of the tequila crisis in Latin America 1994–95, as well as from the more recent experience of Brazil, the Czech Republic, Hong Kong, and Russia, all of which have fended off attacks on their currencies in recent months with a timely and forceful tightening of interest rates along with other supporting policy measures. Once confidence is restored, interest rates can return to more normal levels.”
One may also argue that the external shocks hitting Latin America were more temporary in the post-1998 period, which enabled countercyclical responses. This concern, however, does not seem to be borne by the data because the inertia (as measured by the coefficient of an AR1 process) observed in the Federal funds rate and the commodity index used in Section IV is statistically the same in the pre- and post-1998 periods.
See Cottarelli (2012) and Frankel (2012) on the debate of “austerity vs. growth” which, in our view, is better thought of as a debate over fiscal procyclicality vs. countercyclicality.
The reader is referred to Cavallo, Fernandez-Arias, and Powell (2014) for a much broader discussion of the relevance of Latin American’s past crises for today’s situation in Eurozone countries. We instead limit our focus to the role of procyclical/countercyclical fiscal policy.
The countries are Austria, Belgium, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, and Spain.
Given the short time span and, more importantly, the infrequent changes in tax rates we are unable to construct meaningful correlations between the cyclical components of tax policy and real GDP.
In the terminology used in Frankel, Vegh, and Vuletin (2013), these would be “back to school” cases; that is, cases of “reverse graduation.” In that paper, we also show that, historically, industrial countries have been countercyclical, so this represents a policy shift. The reason behind this policy shift is not easy to ascertain but likely reflects the presumption that long-term gains in terms of fiscal reforms and policy credibility would outweigh the short-term costs of fiscal austerity. But, as is well-known, these policy choices (and their effectiveness so far) continue to be highly controversial even in leading Eurozone countries such as France, and a deeper analysis will need to await the passage of time.
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Additional information
Paper prepared for the 2013 IMF Annual Research Conference in honor of Stanley Fischer’s 70th birthday.
*Carlos A. Vegh is the Fred H. Sanderson Professor of International Economics at SAIS (Johns Hopkins University). He also holds a joint appointment with the Economics Department at Johns Hopkins, is a Research Associate at the National Bureau of Economic Research, and a Non-Resident Senior Fellow at the Brookings Institution. Guillermo Vuletin is a fellow in the Global Economy and Development program and the Global-CERES Economic and Social Policy in Latin America Initiative. He is also a Visiting Professor at SAIS (Johns Hopkins University). The authors are extremely grateful to Julia Ruiz Pozuelo and Collin Rabe for research assistance. On a personal note, Vegh owes a huge debt of gratitude to Stan for 20 years of unwavering mentorship, co-authorship, and support (dating back to Stan’s arrival at the IMF in September 1994). Stan is one of those rare individuals who combines truly remarkable professional credentials with equally astounding personal qualities. Our profuse thanks to Vittorio Corbo as well as to two referees and the editors of this Journal for extremely helpful comments and suggestions.
Appendix
Appendix
Data Definition and Sources
Real GDP: Most data are from Global Financial Data, International Financial Statistics (IFS/IMF), OECD, Eurostat, and CEPAL. In some cases, we used local sources to complement our data: Argentina (Central Bank of Argentina), Brazil (Institute for Applied Economic Research), and Uruguay (Central Bank of Uruguay).
Interest rates: We take short-term interest rates as a proxy for the stance of monetary policy. In some cases, we have data for overnight interbank interest rates, such as the Federal Funds rate in the United States. In most cases, however, we rely on discount rates due to their longer availability. Source: Global Financial Data.
Government spending: In some cases, we have data for final consumption expenditure of general government. In most cases, however, we rely on total government expenditure of general government. Sources: Global Financial Data, IFS/IMF, OECD, and Eurostat.
Taxes: For tax policy we use the cyclical component of a tax index constructed by Vegh and Vuletin (2012). This index is based on VAT, personal, and corporate tax rates as opposed to revenue-based measures such as cyclically adjusted revenues; see Vegh and Vuletin (2012) for details.
Fiscal deficit as percentage of GDP: WEO (IMF).
Total (public plus private) external debt as percentage of GDP: From Reinhart and Rogoff (2009).
Foreign reserves as percentage of GDP: WDI (World Bank).
Current account deficit as percentage of GDP: WEO (IMF).
Chronology of Crises
Table A1 presents a detailed characterization of each of our 34 crises, including background information on the relative importance of domestic vs. external factors.
