- Debt Sustainability and Procyclical Fiscal Policies in Latin America
Fiscal policy is expected to play an important stabilizing role over the business cycle. When the economy is accelerating, the fiscal authorities should be able to moderate activity by restraining the fiscal stance; in downturns, they should use fiscal policy to help stimulate the economy. Fiscal policy should thus behave countercyclically. The empirical evidence, however, has repeatedly shown that fiscal policy is procyclical in many countries, especially in Latin America.1 This situation hurts social policy, and it introduces an additional source of volatility to the economy: when the economy expands, it reinforces the expansion; when it contracts, it deepens the slowdown. Also, according to Servén, the increase in volatility, in turn, reduces investment and growth.2
The neoclassical theory of fiscal policy identifies tax smoothing as a mechanism for accommodating transitory shocks to activity, as long as the intertemporal budget constraint is fulfilled.3 Under those circumstances, public debt fluctuations act as a buffer stock for shocks to activity and enable fiscal policy to play its countercyclical role. The question is what happens when (negative) economic shocks strongly impinge on the level of debt, raising concerns about the fulfillment of the intertemporal budget constraint or, in other words, the sustainability of debt. In those cases the mechanism is short-circuited, and this can jeopardize the stabilizing role of fiscal policy.
This seems to be the case in Latin America. Gavin and Perotti observe that concerns about creditworthiness and sustainability are central to determining fiscal policy stances.4 This situation stems from the dependence of [End Page 157] Latin American finances on external credit sources and the periodic recurrence of sudden stops—that is, the abrupt loss of access to external credit and the volatility of financial indicators, as reflected in volatility in the debt stock and service. Furthermore, periods of difficult access to international capital markets tend to induce restrictive macroeconomic policies, but they also translate into large current account reversals, which are triggered by economic downturns, among other channels. The slowdown in economic activity aggravates fiscal solvency, which, in turn, calls for additional tightening. The capital flow cycle and the macroeconomic policy cycle thus tend to reinforce each other, or, as Kaminsky, Reinhart, and Végh put it, when it rains, it pours in these economies.5
This view on the determinants of procyclicality in fiscal policy implies that the authorities' behavior depends on the impact of fiscal shocks, which prevents them from adopting the right response to the cycle position. An alternative rationale is that the fiscal authority's policy reaction function diverges from expected behavior for institutional or political economy reasons. This approach is best represented by the voracity effects.6 According to this view, the ability to run large budget surpluses in good times is severely hampered by political pressures, which are always present but which are exacerbated in times of plenty. Fiscal resources are wasted in favor of rent-seeking groups, rather than being saved for bad times.7 Lane provides empirical support for political economy factors as determinants of the fiscal policy stance in member countries of the Organization for Economic Cooperation and Development (OECD).8 He recognizes, however, that government debt constraints can seriously limit the room for maneuver for fiscal policy in emerging markets.
Our goal in this paper is twofold: first, to provide an adequate framework for analyzing fiscal policy in Latin America and measuring its procyclicality; and, second, to uncover the underlying reasons for this behavior and thus to ascertain whether the differential fiscal behavior relative to other developed [End Page 158] economies is due to differences in the shocks or constraints affecting these economies or to a different policy reaction function.9 With regard to the first goal, the empirical approaches for rigorously testing and explaining the issue are scant, despite the conventional wisdom that fiscal policy is pro-cyclical in Latin America. The main reason is probably the difficulty of deriving adequate gauges for the fiscal stance in Latin America, stemming from the lack or inadequacy of the data and to the extreme volatility of macroeconomic and financial variables...