NBER macroeconomics annual 1997 ben s bernanke and julio rotemberg

NBER

Macroeconom
Annual
1997

NationalBureauof EconomicResearch


NBER
Macroeconomics

Annual

1997

Editors
and
BenS. Bernanke
JulioJ. Rotemberg

THE MIT PRESS
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London, England


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BYAFFILIATION
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Contents

Editorial: Ben Bernankeand Julio Rotemberg 1
Abstracts

7

FISCALPOLICYIN LATINAMERICA 11
Michael Gavin and RobertoPerotti
COMMENTS:Torsten Persson 61
Aaron Tomell 67
DISCUSSION 70
THE NEOCLASSICALREVIVALIN GROWTHECONOMICS:HAS IT GONE
TOO FAR? 73
Peter Klenow and Andres Rodriguez-Clare
COMMENTS:Greg Mankiw 103
Charles Jones 107
DISCUSSION 113
THE ECONOMICSOF PREFUNDINGSOCIALSECURITY
AND
MEDICAREBENEFITS 115
Martin Feldstein and Andrew Samwick
COMMENTS:Rao Aiyagari 148
Lawrence Kotlikoff 158
DISCUSSION 162
UNEMPLOYMENT
AND
EXPECTATIONS,
JUMPING(S,s) TRIGGERS,
HOUSEHOLDBALANCESHEETS 165
Chris Carrolland Wendy Dunn


vi *CONTENTS

COMMENTS:Angus Deaton 217
Simon Gilchrist 220
DISCUSSION 227
THENEW NEOCLASSICALSYNTHESISAND THEROLEOF
MONETARYPOLICY 231
Marvin Goodfriendand RobertKing
COMMENTS:Ellen McGrattan 283
Olivier Blanchard 289
DISCUSSION 294
FORTHE
FRAMEWORK
AN OPTIMIZATION-BASED
ECONOMETRIC
EVALUATIONOF MONETARYPOLICY 297
Julio Rotembergand Michael Woodford
COMMENTS:Jeffrey Fuhrer 346
Bennett McCallum 355
DISCUSSION 360


NBER

Editorial,
Annual

Macroeconomics

1997

The 1997 edition of the NBER MacroeconomicsAnnual contains, as usual, a

mixture of policy-focused research and studies of broader positive issues
within macroeconomics. Two of the papers are concerned with fiscal
policy: Michael Gavin and Roberto Perotti provide a comprehensive new
data set on fiscal policy in Latin America, which they use both to characterize the cyclical behavior of government budgets in that region and to
develop some hypotheses about the determinants of that behavior. On
the domestic fiscal front, Martin Feldstein and Andrew Samwick propose an approach for changing the U.S. social security system from its
current "pay-as-you-go" format to a fully funded program, and they
discuss the likely effects of this change on the U.S. economy. The volume
also includes two papers on monetary policy: Marvin Goodfriend and
Robert King draw some lessons for monetary policy from what they
perceive to be a new consensus among research-oriented macroeconomists, which they dub the "new neoclassical synthesis"; and Julio
Rotemberg and Michael Woodford compute the properties of optimal
monetary policies for a dynamic sticky-price model of the U.S. economy.
Finally, this issue of the MacroAnnual includes two papers on big issues
of positive economics, as Peter Klenow and Andres Rodriguez revisit the
question of why rates of economic growth differ across countries, and
Christopher Carroll and Wendy Dunn seek to understand how consumer debt and asset holdings help determine the evolution of aggregate consumption.
Gavin and Perotti have painstakingly assembled data on consolidated
government receipts and expenditures for thirteen Latin American countries. Based on these data, the authors demonstrate that there are large
differences between the typical cyclical behavior of fiscal variables in
Latin America and that found in the major industrial countries. The most


2 *BERNANKE& ROTEMBERG
dramatic difference is that fiscal policy tends to be procyclical in Latin
America, with government spending in particular falling during recessions, in contrast to the more familiar pattern of countercyclical fiscal
policy found in most OECD countries. While they cannot completely
rule out other explanations, the authors argue that this procyclical behavior is due primarily to the inability of Latin American governments to
borrow in bad times. Since these are also times in which revenue falls
(revenue is procyclical both in industrial countries and in Latin America,

but somewhat more so in the latter), Latin American governments are
forced to curtail their expenditures at the very time that (from a Keynesian perspective, at least) they may be most needed.
Another interesting set of findings in Gavin and Perotti's paper concerns the connection between the exchange-rate regime and fiscal policy.
It is often alleged that fixed exchange rates induce greater fiscal discipline. The paper shows that this conventional wisdom is not borne out
empirically, at least in Latin America. Periods of fixed exchange rates, it
turns out, are actually associated with larger, rather than smaller, government budget deficits. Moreover, periods of fixed exchange rates often
end in exchange-rate crises, following which, as part of a stabilization
package, deficits are cut. While a sophisticated version of the theory that
fixed exchange rates promote fiscal discipline may still prove correct, the
authors have shown that crude versions of this story do not fit the facts
for Latin America. This finding provoked a lively discussion, with the
formal discussants proving several alternative interpretations of Gavin
and Perotti's results.
In their paper, Klenow and Rodriguez return to the question of
whether one can explain differences in output per capita across countries
by differences in physical and human capital alone, assuming that all
countries have identical production possibilities. An important contribution of their work is the construction of new estimates of human
capital that take into account differences across countries in the return to
schooling at the primary and secondary levels. These data allow the
authors to estimate the extent to which countries' total incomes ought to
vary as a result of differences in schooling (as well as in physical capital).
Klenow and Rodriguez find that these implied differences in income do
not go far in explaining the actual disparity in incomes across countries,
and so conclude that variations in national income levels are mostly due
to differences in productivity, as opposed to differences in inputs. Since
they regard much recent work on growth (the "neoclassical revival") as
having emphasized the latter instead of the former, they call for a change
in the direction of growth research. A particularly challenging fact emerging from this work, as Charles Jones emphasizes in his comments, is that

Editorial 3
countries which are very productive also tend to have high levels of
human and physical capital, i.e., productivity and the level of inputs are
positively correlated. The burning question then becomes whether factor
accumulation causes productivity improvements, because the social returns to human and physical capital are higher than the private return;
or whether differences in productivity that stem from other sources lead
factors to be accumulated.
Feldstein and Samwick's paper suggests that there may be a surprisingly easy solution to the problems of the social security program in the
United States, one that will make essentially everybody better off. They
argue that by slightly increasing taxes on people who are currently working it would be possible to phase out the existing pay-as-you-go system,
under which benefits are paid largely from current worker contributions, in favor of a system in which retirement benefits received by an
individual are financed by that person's own past contributions. The
authors' calculations show that the contributions needed to fund one's
own retirement appear to be quite small relative to the taxes that would
have to be paid under a pay-as-you-go system with the same retirement
benefits. The reason for this difference is that the rate of return on capital
(which is what people would earn on their social security contributions
under the proposed, fully funded system) far exceeds the "rate of return" on contributions to the pay-as-you-go system (which roughly
equals the growth rate of the economy). A critical issue, which received
much attention at the conference, is why there should be such a big
difference between the two rates of return, particularly since the riskfree rate of return in the United States is not much above the economy's
growth rate. As stressed by Rao Aiyagari in his comments, if one takes
the view that the difference between the average return on capital and
the risk-free rate stems from people's aversion to the risks inherent in
holding claims on capital, then the prefunding approach proposed by
Feldstein and Samwick is less attractive; people would not feel that the
higher expected return available under prefunding fully compensates
them for the additional risk they would bear. On the other hand, Feldstein and Samwick's proposal is more attractive if one believes that the
difference in returns arises from limited participation in equity markets,
since in this case prefunding would provide less well-off people an

opportunity to earn much more on their contributions than they have
been able to in the past.
Another important, and related, issue pertinent to Feldstein and Samwick's proposal is the extent to which it would increase national saving.
The authors suggest a positive saving effect, arising because a mandatory
increase in contributions, by reducing current resources, should act to


4 *BERNANKE& ROTEMBERG
depress consumption. In his comments, Lawrence Kotlikoff expressed
some skepticism about the empirical importance of this channel, suggesting that in reality people would simply offset increased social security
contributions by reducing other forms of saving (although whether the
majority of the population has sufficient liquid assets to do this is debatable). Kotlikoff thought that the proposal might indeed increase saving,
but rather through a second potential channel: He argued that the elimination of future transfers from the young to the old would effectively
reduce the wealth of those people currently working, thereby inducing
them to consume less.
Carroll and Dunn develop the idea, which has been advanced by policymakers such as Alan Greenspan, that increased borrowing by consumers
during the 1980s has made aggregate consumption more vulnerable to
changes in consumer sentiment. In the first part of their paper they provide some evidence on the determinants of consumption, the strongest
finding being that consumption appears to be particularly sensitive to
people's beliefs about the risks of becoming unemployed; however, the
reduced-form relationships between consumption and measures of indebtedness are generally found to be weak. The greatest portion of Carroll
and Dunn's paper is devoted to the development of a theoretical model
which attempts to rationalize Greenspan's hypothesis by studying the
behavior of individuals who (1) must choose whether to rent or own their
home and (2) are motivated to keep a buffer stock of liquid assets that can
be used for unforeseen contingencies. It is assumed that homeownership
is cheaper in the long run than renting but involves the commitment of
both a down payment and a future stream of mortgage payments, which
can be changed only by bearing the heavy transaction costs of selling the
home. Thus in deciding to purchase a house the consumer faces a tradeoff

between lower expected living costs on the one hand, and greater financial flexibility in the face of possibly adverse income shocks on the other.
The model is difficult to solve, even numerically, because of the large
number of state variables. However, simulations of the model do suggest that when consumers become more pessimistic about their future
employment prospects, they attempt to increase their buffer stocks of
liquid assets and are thus less willing to make a down payment on a
house. Further, the model can reproduce the stylized facts about the
1980s, in that a credit-market liberalization (e.g., a reduction in the required down payment) is shown to lead to a runup in consumer debt,
and the higher debt burden in turn increases the sensitivity of consumer
spending to labor-market uncertainty. Much of the discussion of the
paper concerned how a complex simulation model of the sort used in
this paper should be tested and evaluated, given that (because of compu-


Editorial 5
tational considerations) it is possible to conduct simulations for only a
small number of parameter values.
Goodfriend and King see macroeconomics evolving towards a new
consensus, which combines new Keynesian theories of price stickiness
and imperfect competition with the real business cycle (RBC) assumption that the behavior of consumption, investment, and labor supply can
be rationalized as choices of optimizing agents in a dynamic, stochastic
environment. They call this emerging consensus the "new neoclassical
synthesis" (NNS), in honor of Paul Samuelson's original vision (which
also blended classical and Keynesian elements). Much of the paper is
devoted to drawing out the implications of this modem eclectic approach for monetary policy.
Goodfriend and King argue that the new synthesis has clear and practically useful policy implications, and they consider a variety of issues,
such as the optimal policy response to an oil price shock. A main result is
that monetary policy ought to stabilize prices, so that the effects of aggregate demand shocks are minimized and allocations mimic as closely as
possible those implied by the RBC theory. The authors also point out the
difficulties inherent in using interest rates as an intermediate target for
monetary policy, since in the NNS framework the nominal interest rate

consistent with the optimal monetary policy will depend in a complex
way on the shocks hitting the economy and on whether those shocks are
expected to be temporary or permanent.
Rotemberg and Woodford present a model that incorporates many
elements of the synthesis outlined by Goodfriend and King. In particular, they analyze the properties of optimal monetary policy in a relatively
spare but fully dynamic framework that includes lags in price adjustment and (conditional on these lags) assumes optimizing behavior by
consumers, workers, and firms. This model is able to mimic closely the
observed responses of output, inflation, and the federal funds rate to
monetary policy shocks (which are defined in a vector autoregression
setting as movements in interest rates that are not predictable by other
variables). Rotemberg and Woodford argue that this criterion is the correct one by which to judge the fit of the model, as the focus of the
analysis is on monetary policy and the determinants of aggregate demand and supply are not modeled in detail, but are treated rather as
autonomous disturbances.
The authors then compute how monetary policy ought to respond to
disturbances to spending and aggregate supply. They show that complete stabilization of inflation is possible in general but that, under the
assumption that disturbances affecting private decisions are not immediately observed by policymakers, this complete stabilization may require


6 - BERNANKE& ROTEMBERG
large swings in interest rates. Since nominal interest rates cannot be
negative, feasibility of inflation stabilization may therefore require that
average interest rates-and hence inflation-be quite high. Noting this
tradeoff between the level and variability of inflation, the authors conclude that it is best to allow inflation to change slightly from period to
period. Nevertheless, an optimal monetary policy, according to the
Rotemberg-Woodford model, would have stabilized inflation considerably more than did actual U.S. policy.
The most debated aspect of the paper was whether it is legitimate to
use a modeling strategy which results in the bulk of the fluctuations in
output and inflation being attributed to serially correlateddisturbances to
aggregate demand and supply. Several participants, including the discussants, suggested that they would have preferred a model with a less
complicated error structure and with more of the serial correlation of

output and inflation explained by explicitly modeled, internal propagation mechanisms.
We close with some acknowledgments. First, we owe a debt of thanks
to the NBER's conference department, who managed the conference's
logistics and made sure everything ran smoothly. Don Redl did an excellent job as assistant editor of the volume. Finally, we thank Martin Feldstein, the National Bureau, and the National Science Foundation for
continued support of the Macro Annual conference and publication,
now in its twelfth year.
Ben S. Bernanke and Julio J. Rotemberg


Abstracts
FiscalPolicyin LatinAmerica
MICHAEL GAVIN AND ROBERTOPEROTTI
Fiscal policy in Latin America has been understudied, in part because of inadequate data. This paper utilizes a new, comprehensive database on fiscal outcomes in 13 major Latin American economies which covers central government,
local government, and nonfinancial public enterprises at a reasonably detailed
level of aggregation. Armed with this database, we lay out some basic facts about
fiscal policy in Latin America. We find stark differences between fiscal outcomes
in Latin America and in industrial countries. Fiscal outcomes have been far more
volatile in Latin America. In sharp contrast to the industrial economies, fiscal
policy in Latin America has also been procyclical, casting doubt on the applicability of the Barro (1979) tax-smoothing hypothesis to Latin America. We discuss
alternative explanations of fiscal policy procyclicality. We also consider the relationship of fiscal policy to the exchange-rate regime. Contrary to much conventional wisdom, we find no evidence that fixed exchange rates impose greater
discipline on fiscal policy. We also find that fiscal expansions in Latin America
have been significantly associated with exchange-rate collapses.

TheNeoclassical
Revivalin GrowthEconomics:
Has it Gone
TooFar?
JETERKJ. KLENOW AND ANDRES RODRiGUEZ-CLARE

In our view there has been a "Neoclassical Revival" in growth economics

spurred by the empirical findings of Mankiw, Romer, and Weil (1992), Barro and
Sala-i-Martin (1995), and Young (1994 and 1995). By this we mean a revival of the
neoclassical growth model-which features a common level of productivity but
different levels of human and physical capital across countries-as a viable candidate for explaining the major part of country differences in levels and growth
rates of output per worker. Marshaling existing evidence from the labor literature on the returns to schooling and experience, we construct new measures of
human capital across countries. We find that productivity differences are the


8 ABSTRACTS
dominant source of the large international dispersion in levels and growth rates
of output per worker. We conclude that, although models that focus on physical
and human capital are clearly important, research needs to be re-focused on
explaining the causes of productivity differences across countries.

TheEconomics
SocialSecurityandMedicare
of Prefunding
Benefits
MARTIN FELDSTEIN AND ANDREW SAMWICK
This paper presents a detailed analysis of the economics of prefunding benefits
for the aged, focusing on social security but indicating some of the analogous
magnitudes for prefunding Medicare benefits. We use detailed census and social
security information to model the transition to a fully funded system based on
mandatory contributions to individual accounts. The funded system that we
examine would permanently maintain the level of benefits now specified in
current law and would require no new government borrowing (other than eventually selling the bonds that are officially in the social security trust fund). During the transition, the combined rate of payroll tax and mandatory saving rises
initially by 2 percentage points (to a total of 14.4%) and then declines so that, in
less than 20 years, it is less than the current 12.4% payroll tax. We estimate the
influence of such prefunding on the growth of the capital stock and the level of
national income and show that the combination of higher pretax wages and

lower payroll taxes could raise wages net of income and payroll taxes by more
than 35% in the long run. We also discuss distributional issues and the way that
the poor can be at least as well off as under social security. A stochastic simulation shows that a small increase in the mandatory saving rate would reduce the
risk of receiving less than the scheduled level to less than 1%. Separate calculations are presented of the value of the "forward-looking recognition bonds" and
"backward-looking recognition bonds" which the government might issue if it
decides not to pay future social security benefits explicitly.

and
Expectations,
Jumping(S,s) Triggers,
Unemployment
BalanceSheets
Household
CHRISTOPHER D. CARROLL AND WENDY E. DUNN
This paper examines the relationship between household balance sheets, consumer purchases, and expectations. We find few robust empirical relationships
between balance sheet measures and spending, but we do find that unemployment expectations are robustly correlated with spending. We then construct a
formal model of durables and nondurables consumption with an explicit role for
unemployment and for household debt. We find that the model is capable of
explaining several empirical regularities which are, at best, unexplained by standard models. Finally, we show that a loosening of liquidity constraints can produce a runup in debt similar to that experienced recently in the United States, and


Abstracts 9
that after such a liberalization consumer purchases show heightened sensitivity to
labor income uncertainty, providing a potential rigorous interpretation of the
widespread view that the buildup of debt in the 1980s may have played an important role in the weakness of consumption during and after the 1990 recession.

TheNew Neoclassical
SynthesisandtheRoleof Monetary
Policy
MARVIN GOODFRIEND AND ROBERTG. KING

Macroeconomics is moving toward a New Neoclassical Synthesis, which like the
synthesis of the 1960s melds classical with Keynesian ideas. This paper describes
the key features of the new synthesis and its implications for the role of monetary policy. We find that the New Neoclassical Synthesis rationalizes an activist
monetary policy, which is a simple system of inflation targets. Under this "neutral" monetary policy, real quantities evolve as suggested in the literature on real
business cycles. Going beyond broad principles, we use the new synthesis to
address several operational aspects of inflation targeting. These include its practicality, the response to oil shocks, the choice of price index, the design of a
mandate, and the tactics of interest rate policy.

An Optimization-Based
Econometric
Framework
for the
Evaluation
of MonetaryPolicy
JULIO J. ROTEMBERGAND MICHAEL WOODFORD
This paper considers a simple quantitative model of output, interest rate and
inflation determination in the United States, and uses it to evaluate alternative
rules by which the Fed may set interest rates. The model is derived from optimizing behavior under rational expectations, both on the part of the purchasers of
goods (who choose quantities to purchase given the expected path of real interest rates), and upon that of the sellers of goods (who set prices on the basis of the
expected evolution of demand). Numerical parameter values are obtained in part
by seeking to match the actual responses of the economy to a monetary shock to
the responses predicted by the model. The resulting model matches the empirical responses quite well and, once due account is taken of its structural disturbances, can account for our data nearly as well as an unrestricted VAR. The
monetary policy rule that most reduces inflation variability (and is best on this
account) requires very variable interest rates, which in turn is possible only in
the case of a high average inflation rate. But even in the case of a constrainedoptimal policy, that takes into account some of the costs of average inflation and
constrains the variability of interest rates so as to keep average inflation low,
inflation would be stabilized considerably more and output stabilized considerably less than under our estimates of current policy. Moreover, this constrainedoptimal policy also allows average inflation to be much smaller.


MichaelGavinandRobertoPerotti

INTER-AMERICAN
DEVELOPMENT
BANK;AND COLUMBIAUNIVERSITY
AND CEPR

Fiscal

Policy

in

Latin

America

1. Introduction
Macroeconomic analysis of Latin America has long been primarily an
exercise in monetary analysis. Fiscal policy has always formed part of
this study, but the emphasis has typically been on fiscal deficits only,
with the interest primarily centered on their effect on monetary outcomes and inflation. This emphasis is understandable, in light of the
region's history of monetary and financial instability, but the time may
be ripe for a.change. While inflation has not vanished from Latin America, over the course of the past decade it has fallen nearly to single-digit
levels. There is good reason to hope that Latin America will no longer be
a breeding ground for the extreme and exotic monetary experiments that
have in the past occupied monetary economists around the world. If so,
policymakers in the region will have scope to turn their attention to
other policy problems, and students of economic policy will have to
search elsewhere for lessons.
We think that fiscal policy is one area that ought to be high on the
agenda for both policymakers and researchers. In our view, Latin American fiscal policy has been under-studied, perhaps with adverse implications for policy, and certainly with lost opportunities to confront theories,

Prepared for the NBER MacroeconomicsAnnual, 1997. The authors thank Ben Beranke,
Ricardo Hausmann, Philip Lane, Torsten Persson, Julio Rotemberg, Emesto Talvi, Vito
Tanzi, Aaron Tornell, and Andres Velasco for useful comments and discussions. Construction of the database involved contributions from a larger number of individuals in Latin
America and outside. For this assistance the authors thank Francisco Alpizar, Vilma Calvo,
Alberto Carresquilla, Javier Comboni, Gustavo Garcia, Luis Carlos Jemio, Martin Kaufman, Carlos Oliva, Inder Ruprah, Andrew Powell, Jose Seligman, Carola Soto Beirutti, and
Alejandro Werner, and apologize to anyone they forgot. Raquel Ajona, Michael Kumhof,
Doug Smith, and Erik Wachtenheim provided valuable research assistance. Brendan Cunningham and Jennifer Wang also assisted with preparation of the database. Roberto
Perotti's research was partially supported by NSF grant No. SBR-9414719.


12 - GAVIN& PEROTTI
such as the idea that the tax-smoothing model is a useful positive as well
as normative model of fiscal policy, against an illuminating body of historical experience.
One reason for this lack of attention to many dimensions of fiscal
policy in the region is the difficulties that confront researchers attempting to obtain data on fiscal outcomes. The standard data source is the
International Monetary Fund's Government Finance Statistics, whose
coverage of Latin America is, however, largely limited to central governments, and even there has important gaps. The coverage of local governments is spotty, and provides only a limited breakdown of different
budgetary aggregates. This poses a serious limitation for cross-country
comparative work, particularly work involving important federal countries such as Argentina and Brazil. The publication was never intended
to cover public-enterprise finance, which is, again, an important limitation in a region where public enterprises have long been a central element of the fiscal picture. Thus, one contribution of this paper is the
creation of a comprehensive database on fiscal outcomes in 13 major
Latin American economies, which covers central government, local governments, and nonfinancial public enterprises at a reasonably detailed
level of aggregation.
Armed with this database, our purpose in this paper is to lay out some
basic facts about fiscal outcomes in Latin America. We think that the basic
characteristics of fiscal policymaking in the region are sufficiently unfamiliar that a straightforward and transparent examination of the data,
not excessively colored by a particular model structure, is called for at
this point. Of course, the predictions of the large body of theoretical
literature on fiscal policy-although mainly developed with industrialcountry experience in mind-have determined the questions that we ask
of the data. And some form of benchmark is required to make meaningful statements about the data. But rather than confront the data with the

orthogonality conditions implied by a specific theoretical model, we have
used the industrial-country experience as our standard of comparison.
Nobody would argue that fiscal policy is determined optimally in the industrial countries, but their experience has the advantage of having been
intensively studied and in many cases rationalized theoretically. When
we identify sharp differences between Latin American and industrialcountry patterns, we hope to learn not only about Latin America, but
also about the generality of theories that seek to explain industrialcountry experience.
We do in fact find stark, qualitative differences between Latin American and industrial-country fiscal outcomes. Fiscal outcomes have been
far more volatile in Latin America than in the industrial economies. And,


Fiscal Policy in Latin America * 13

in sharp contrast to the industrial economies, fiscal policy has been
procyclical, and particularly so in recessions, casting doubt on the applicability of the Barro (1979) tax-smoothing hypothesis for Latin America.
We then turn to an analysis of the relationship between fiscal policy and
the exchange-rate regime. Countrary to much-though
by no means
all-conventional
wisdom, we find no evidence that fixed-exchangerate regimes impose greater fiscal discipline, and some evidence that the
reverse may be true. We also find that fiscal shocks have been more
disruptive than is typically observed in the industrial economies, uncovering evidence that in Latin America expansionary fiscal expansions
have been significantly associated with exchange-rate collapses.
Some of these differences seem to us difficult to rationalize with existing theoretical frameworks for optimal fiscal policy. We think that this
should concern policymakers in the region, and motivate them to understand better why fiscal policymaking seems to have fallen short of its
potential. And we think that the Latin American experience should interest students of fiscal policy in the industrial economies, providing as it
does a range of experience against which to evaluate existing theoretical
frameworks.
The paper is organized as follows. In the following section we describe
the database of fiscal outcomes that we use in this study, including
certain methodological issues associated with its development. In Section 3 we give a brief overview of fiscal structures in Latin America,

covering the size and composition of the typical Latin American budget,
and the role of local government and nonfinancial public enterprises. In
Section 4 we analyze the cyclical properties of Latin American fiscal
outcomes. Section 5 studies linkages between exchange-rate regimes,
fiscal outcomes, and macroeconomic stability, and Section 6 concludes.

2. TheDatabaseandMethodological
Issues
Our database on public finance in Latin America includes 13 countries,1
covering a maximum period spanning 1968 to 1995. In this section, we
offer a brief description of the main features of this dataset and of some
methodological issues involved in its construction.2 In so doing, we also
briefly touch on some important institutional characteristics of fiscal policy in Latin America, which are essential for an understanding of its
behavior in the past 25 years.
1. The countries are: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador,
Mexico, Panama,Paraguay,Peru, Uruguay,and Venezuela.
2. A more complete description of the database, its sources, and methodology can be
found in Perotti(1997).


14 *GAVIN& PEROTTI
2.1 COVERAGEOF SECTORS
The database includes not only the central government, but also the sum
of state, provincial, and municipal governments (henceforth, local governments) and the nonfinancial public enterprises.
In several countries, local governments have access to a large share of
total taxes, either directly or through revenue-sharing agreements, and
perform important functions on the expenditure side (see Table 4, below,
for information on the size and composition of expenditure and revenues of local governments in both Latin America and industrialized
countries). Obviously, a cross-section study of fiscal policy could give a
misleading picture if it did not include local governments as well. But

there are important reasons why local governments are important even
in studying the time-series aspects of fiscal policy in Latin America.
Revenue-sharing agreements and the formal allocation of revenues and
functions to different levels of governments have shifted over time,
distorting the meaning of data at the central government level. For instance, in 1985 the revenue-sharing agreement between the central government and the provinces broke down in Argentina, causing many
taxes that were previously classified as provincial taxes to be reclassified
as central government taxes. As a consequence, the recorded revenues
of the central government increased suddenly by about 3% of GDP; but
this was obviously offset by a similar increase in transfers to the provinces. A study that utilized central-government data alone might reach
quite misleading conclusions about fiscal developments in that year.
One of our key findings is that fiscal policy in Latin America has been
procyclical, and therefore economically destabilizing, while the opposite
holds in industrialized economies. Since local governments typically
have a much more limited ability to conduct a countercyclical fiscal policy, the size and behavior of local governments in the two regions might
be an important factor underlying this result. With our database, we are
able to assess-and reject-this explanation for our findings.
Finally, the claim is often heard that local governments are among the
key reasons behind many episodes of runaway fiscal policy, as local
governments under political pressure initiate highly expansionary policies with the knowledge that the central government will foot the bill
later. The bailout process might take several forms, such as an increase
in the share of provinces in taxation in formal revenue-sharing agreements, or an increase in unconditional grants, or the assumption by the
central government of arrears incurred by local governments, as in Brazil. These policy issues are becoming increasingly germane as governments in the region devolve authority to local governments, including in


FiscalPolicyin LatinAmerica*15
many cases the authority to borrow domestically and internationally. To
assess the relevance of the dangers that might be posed by this devolution, one clearly needs data on the role of local governments.
In virtually all Latin American countries, there is also an extensive
network of nonfinancial public enterprises (henceforth, NFPEs) that
have often been key players in the region's fiscal drama.3 (Table 6,

below, presents the main summary statistics on NFPEs.) NFPEs often
are the single largest source of revenues to the government, not only
which case they would not be different from other
tax revenues-in
enterprises-but also nontax revenues through profit transfers. On the
other hand, money-losing public enterprises are often recipients of
large current or capital transfers from the government. Because many
public enterprises-and in general the largest ones-operate in the key
export sectors, such as oil in Mexico and Venezuela, copper in Chile,
and coffee in Columbia, fluctuations in export prices are a primary
source of fluctuations in government resources. Finally, NFPEs have
often played a key role in the employment policy of the government.
For all these reasons, it is essential to include information on both local
governments and NFPEs for all countries in the sample, and our dataset
does so. This allows us to construct series for the general government
(the consolidation of the central and local governments) and for the
nonfinancial public sector (the consolidation of the general government
and the NFPEs).
As argued above, flows of resources between different levels of government (including NFPEs) pose important analytical and policy issues,
and a full understanding of the behavior of fiscal policy in Latin America
requires an understanding of these flows. Hence, our dataset includes
information on the transfers between different levels of the nonfinancial
public sector. In consolidating the different levels of the nonfinancial
public sector, we take into account these intersectoral flows.
An important issue of coverage arises also within the central government. In most Latin American fiscal systems, "decentralized agencies"
outside the main budget often receive large amounts of earmarked revenues, and carry out important expenditure functions. The same, of
course, holds for social security systems, which receive the bulk of social
security taxes, and often substantial transfers from the central administration. Hence, our definition of central government generally includes
3. Gavin (1997) estimates that subsidies provided in the form of below-marketprices
charged by the public petroleumcompany accountedfor nearly 3/4 of the oil windfall

that accruedto the Mexicanpublic sector during 1978-1982,amountingto 4%to 5%of
GDP in 1980-1982. More recently, similar price subsidies have had enormous fiscal
impactsin Venezuela.


16 ?GAVIN& PEROTTI
these agencies, in addition to the central administration, which is typically covered by the national budget.4
2.2 BREAKDOWNOF THEBUDGET
While several existing studies of fiscal policy in Latin America focus
mainly on the deficit, or at most total expenditure and revenues, we are
interested in a more refined breakdown, for two main reasons. First,
different budget items have different macroeconomic effects. Second, a
decomposition of the budget is crucial for an understanding of the determinants of fiscal outcomes. For instance, as we show later, many of our
findings on the cyclical sensitivity of fiscal policy in Latin America are
unlikely to be interpretable as the result of the optimizing behavior of a
benevolent dictator. Hence, we need more realistic positive models of
fiscal policy in order to interpret these results; in this case, information
on components of revenues and, in particular, expenditure can be of key
importance in assessing the empirical relevance of the different positive
models.
It is equally important specifically to include gross operating expenditures and revenues of nonfinancial public enterprises, rather than only
the net operating surplus, because of the frequent use of NFPEs for
employment purposes. Furthermore, we disaggregate operating expenditures into their wage and nonwage components, and operating revenues into sales and others. Besides operating revenues and expenditures, we have data on interest payments, transfers to and from the
central government including taxes, and capital expenditure.5 This disaggregation is available for most years in every country.
2.3 QUASIFISCALDEFICITS
The basic idea underlying the notion of the quasifiscal deficit is that it
should capture all those transfers of resources from the public sector to
the private sector that occur indirectly through the operations of the
financial public sector. Thus, this notion should capture, among others,
the transfers implicit in exchange-rate guarantees by the central bank,

multiple-exchange-rate arrangements, interest-rate controls, etc. Because
4. Our primary source of information for the central government, the IMF Government
Finance Statistics (which we use for 11 of the 13 countries), sometimes reports only data
on the Central Administration, particularly in the 1970s or in the 1990s. When this
happens, we supplement the Government Finance Statistics with data on the decentralized agencies and the social security system, whenever available. So far, we have been
unable to incorporate decentralized agencies in Costa Rica prior to 1987.
5. For many country-years, capital expenditure can be further disaggregated into capital
formation, lending minus repayment, and capital transfers. Also, for many countryyears we have separate data on other nontax revenues.


FiscalPolicyin LatinAmerica*17
of the extensive use of these policies in Latin America in the 1980s, the
quasifiscal deficit can reach staggering proportions. For instance, according to Easterly, Rodriguez, and Schmidt-Hebbel (1994), in 1982 the
quasifiscal deficit in Argentina was 25% of GDP.
While we recognize the importance of the quasifiscal deficit for certain
purposes, we do not use it in our analysis, for two main reasons. First,
and most importantly, in our view it mixes stocks and flows in a way that
is difficult to rationalize. For instance, the face value of exchange-rate
stock variable-often appears as a component of the
guarantees-a
even though the central bank might never be called
deficit,
quasifiscal
to
make
upon
good these guarantees, and therefore there might never be
a cash flow associated with them.6 Second, measures of the quasifiscal
deficit inevitably require highly subjective judgements; exactly because it
is meant to capture all implicit transfers, there is virtually no end to the

items one might want to include in it. In fact, Mackenzie and Stella (1996)
list a total of 11 candidate components of the quasifiscal deficit, among
which are "poorly secured and subpar loans" and "preferential rediscounting practices." The problems in quantifying these components, and
in ensuring a minimum of comparability across countries, seem evident.
2.4 INFLATIONAND DATAQUALITY
Government accounts are among the many victims of the frequent
bursts of inflation and hyperinflation in Latin America. At high levels of
inflation, the interpretation of many budget figures becomes extremely
difficult. The most obvious problem is with the treatment of interest
payments, which can reach staggering proportions during hyperinflations (easily on the order of 20% of GDP). The preferred solution to this
problem is to compute the real component of interest payments on domestic debt. However, data on the currency composition of public debt
are available only for a few countries, mostly for the central government
only, and rarely on a consistent basis. Our solution to this problem is to
make extensive use of the primary surplus in our analysis, and to ensure
that the results that we report are not unduly influenced by these potentially problematic data by dropping all country-years with very high
inflation. The results that we report are robust to these checks. But
problems of data quality are not confined to interest payments and to
hyperinflations, particularly once one moves away from the central government. We encountered substantial variation across countries and
over time in the quality of fiscal accounts: some countries-such
as
6. This also means that the quasifiscal deficit is inconsistent with the cash basis for recording transactions that we adopt, whenever possible, in our Latin American database.


18 * GAVIN & PEROTTI
to maintain very reliable accounts at all levels of the
Costa Rica-seem
while
in other countries, the quality of the information
public sector,
deteriorates sharply in some periods, such as data on local governments

in Venezuela during the last decade. To test the robustness of our results, we have constructed a low-quality sample, based on our subjective
assessment of the quality of the data, and we rountinely exclude the lowquality data from our estimates. Here also we find that low-quality observations are not major outliers in our estimates. Finally, as a further check
of robustness, we routinely re-estimate our regressions, dropping one
country at a time.

3. A Bird's-EyeViewof FiscalPolicyin LatinAmerica
In this section, we briefly describe the main stylized facts of various fiscal
aggregates in Latin America over the last 25 years.7 Throughout this
section, our comments will focus on two main dimensions: a comparison
of averages over the whole period between Latin America and the group
of industrialized countries,8 and the main changes over time within each
group. We begin with the general government, which is the natural unit
of comparison between the two groups of countries.
3.1 FIRST MOMENTS
Table 1 presents simple averages of the main fiscal aggregates of the
general government in Latin America and industrialized countries, over
the whole 1970-1995 period and over each decade separately.9 This table
7. Toensure consistencybetween the aggregatesand theircomponents,we only use those
country-years that include all main componentsof expenditures,and for both the centraland localgovernments.This ensures that the deficitsof each subsectorare consistent
with aggregate expenditure and revenues, and that the general-governmentbudget
items are equal to the sum of the same items of the centraland localgovernments.Thus,
the total numberof observationsin these tablescan be less than the total numberin the
regressionsof the next sections. Notice that total expenditureand revenues can still be
slightly differentfrom the sum of theircomponentsbecauseof severaladjustmentsthat
are occasionally made to the total, such as cash adjustments or adjustments for tax
creditsin some countries, which cannotbe allocatedto any specificcomponent.
8. Our sample of industrializedcountries consists of Australia,Austria, Belgium, Denmark, Finland, France, Germany,Ireland, Italy,Japan, Netherlands, Norway, Spain,
Sweden, the United Kingdom, and the United States. Our sources are the OECDNaNationalIncomeAccounts.When we compare
tionalIncomeAccountsand EUROSTATs
central-governmenttaxesacrossthe two regions,forconsistencywe use the IMFGovernment FinanceStatisticsalso for the industrialcountries.

9. In presenting these summary statistics, we face the choice between unweighted and
weighted averages. Each has its advantages, but we opted for the former because
Braziland Mexico together account for more than 60%of the total population in our
sample of LatinAmericancountries,giving theirexperiencedisproportionateweight in
a population-weightedaggregate.


Fiscal Policy in Latin America* 19
Table 1 RELATIVESIZE OF GENERAL GOVERNMENT
Value (%)
Region
,H
,,ram,,,,,,,,m m

m

1970-95
m

m

m

1980-89

1970-79
,

m

m

m

m

~~~~
.

1990-95

Total surplus/GDP

Latin America
Industrial
economies

-1.4
-2.5

-1.3
-0.8

-2.4
-3.3

0.5
-4.1

Total surplus/total

revenue

Latin America
Industrial
economies

-10.6
-6.5

-9.5
-3.1

-17.3
-8.5

1.4
-9.2

Primary surplus/
GDP

Latin America
Industrial
economies

1.3
-0.4

-0.3
-0.0

1.0
-0.5

3.6
-0.8

Primary surplus/
total revenue

Latin America
Industrial
economies

1.1
-1.3

-3.2
-0.8

-2.1
-1.7

14.0
-1.7

Total revenue/
GDP

Latin America

Industrial
economies

21.6
42.1

20.4
38.6

21.8
43.6

23.2
45.5

Total expenditure/
GDP

Latin America
Industrial
economies

22.9
44.6

21.7
39.5

24.0
46.9

22.2
49.6

Primary expenditure/GDP

Latin America
Industrial
economies

20.2
42.4

20.4
38.6

20.6
44.1

19.1
46.3

Simple averagesof countrydata. Numberof observations:LatinAmerica,276;industrialeconomies,
413.

provides a substantial amount of information; here we highlight the
main points.
First, a comparison of the size of deficits in Latin American and industrialized countries largely depends on the metric one adopts.10 As shares
of GDP, the average deficit over the whole period has been virtually
10. In this section, deficitsin both groupsof countriesarenet of lending minus repayment.

This choice is dictatedby the factthat the sourceof informationfor the group of industrialized countries is the National Income Accounts by the OECD and EUROSTAT,
which recordlending minus repaymentbelow the line. Also, for LatinAmericancountries we only have informationabout gross interest payments of the general government; therefore,in Table1 we define the primarydeficitas the overalldeficitnet of net
interest payments in industrializedcountries, and net of gross interest payments in
Latin America. The difference is unlikely to be large, since interest received by the
government is generally small.


20 - GAVIN& PEROTTI
identical in the two regions. On the other hand, the average deficit in
Latin America has been substantially larger than in industrialized countries if measured as a share of tax revenues, which might be a better
indicator of the ability of a country to service its debt.
These averages over the whole period obscure important differences
over the two and a half decades of the sample. Latin America as a region
displays a remarkable fiscal consolidation in the 1990s, with a fall in the
average deficit relative to the 1980s by about 3% of GDP, while in the
industralized countries the deficit rose steadily throughout the period. If
one looks at the primary deficit, this difference is even more marked,
with steady improvement by a cumulated 3.7% of GDP.
Second, the average size of the Latin American state, as measured by
total revenues, is about half that (21.6% of GDP) of the industrial countries (42.1% of GDP). It is important to note that the capacity to raise
revenues of Latin American countries has grown only minimally over
time (especially considering the low initial level): by only about 2.5% of
GDP over the whole period, against an increase by 7% of GDP in the
industrialized world. Third, the development over time of expenditure in
the two regions shows an even more marked difference. In Latin America, the share of total expenditure to GDP has been remarkably stable,
increasing in the 1980s by slightly more than 2% of GDP, but only because
of the increase in interest payments. In fact, the share of primary expenditure in GDP stayed constant at about 20.5% in the 1970s and 1980s, and
declines to 19.4% in the 1990s. Exactly the opposite pattern occurs in the
industralized region, where both total and primary expenditure increased steadily, and substantially-9% and 8% of GDP, respectively.
Fourth, the composition and evolution of revenues and expenditure

(see Table 2) differs in the two regions. On the revenue side, notice the
much larger share of nontax revenues in Latin America. This is a particularly volatile source of revenues, because it includes transfers of profits
from fiscal monopolies and state-owned enterprises, royalties from oil
extraction, etc. A comparison of the structure of tax revenue is possible
only for the central government, because the numbers of observations
on the individual revenue items of local governments drop substantially
in Latin America. This table illustrates some familiar results, and some
less familiar ones.
First, Latin American countries rely much more on indirect taxes (including taxes on international trade) than do industrialized countries. By
the same token, the share of direct taxes is much smaller in Latin America. Furthermore, about 80% of income taxes in Latin America fall on
corporations (a particularly volatile tax revenue) and 20% on individuals.
In the industrialized countries, this proportion is virtually reversed.