Macroeconomic Gains from Structural Fiscal Policy Adjustments: The Case of Colombia

Policymakers worldwide are drawing key lessons from recent academic debates on the role of fiscal policy in the recovery of advanced economies. Many emerging markets have already addressed some of the focal issues currently being discussed, in response to the collapse of their economies in the late 1990s. Some of the key issues include the timing of adjustments and their progressive nature; the need for fiscal stimulus programs and their scope; the proper choice of fiscal instruments and their potential effectiveness along the cycle; and the appropriate public-debt threshold to avoid hampering economic growth.¹ Regardless of the tenets followed, many governments were compelled to adopt tight financial stances in this earlier episode, mostly due to credit market restrictions.

By the turn of the century, Colombia, like several other Latin American countries, was on a growth-recovery path based on a broad set of structural economic reforms. In particular, the Central Bank of Colombia had adopted an inflation-targeting regime with a floating exchange rate, which enhanced the institution’s credibility and counteracted external shocks. The government also implemented prudential measures to strengthen the financial system and labor market policies to promote flexibility and competitiveness, and the economy was becoming increasingly integrated into global trade and financial markets. However, the cornerstone of all the reforms was the rebalancing of the government’s finances by improving its revenues, rationalizing expenditures, and establishing new and effective institutions. The overarching goal was to attain a sustainable path for the country’s public debt, as well as its long-term economic growth.

Not surprisingly, this set of cautious policies had further effects on the short- and long-term behavior of the macroeconomy, particularly its response to exogenous shocks. First, the country overcame a rising and unsustainable debt path through a series of reforms that decreased the ratio of debt to gross domestic product (GDP) between 2003 and 2008 and fostered its current stability. Second, explicit policies to diminish the currency mismatch of the government’s finances lessened their vulnerability to sharp depreciation episodes and adverse external shocks. Third, the composition of the public debt was shifted toward fixed-rate, peso-denominated bonds with longer maturities, thereby deepening the local sovereign debt market.

This paper highlights some relevant aspects of Colombia’s fiscal policy and public debt management during the past ten years and assesses some of their short-term macroeconomic effects. In particular, we analyze the influence of fiscal policy changes on the short-term output response to fiscal shocks and the impact of monetary policy shocks on market interest rates. To do so, we used the structural nonlinear impulse response functions suggested by Auerbach and Gorodnichenko and by Jordà.² We also identify the unexpected fiscal and monetary policy shocks through methods inspired by the narrative approach of Romer and Romer and also Ramey.³ We conclude that a sound fiscal policy brings strong countercyclical benefits to both monetary and fiscal decisions.

Fiscal Policy in Colombia

The adoption of a new constitution in 1991 implied a strong expansion of the size of government in Colombia. Increased demand for public spending on health, education, and justice drove the central government’s primary expenditures from 7.2 percent of GDP in 1990 to 12.4 percent of GDP in 2000. At the same time, the constitution of 1991 and legal reforms extended fiscal decentralization and imposed a regime in which an increasing fraction of the central government’s current revenues was transferred to local governments. The tax increases adopted to pay for the additional expenditures were not sufficient and had to be shared with local governments, which, in turn, increased their spending. In addition, the intertemporal solvency of the pay-as-you-go national pension system was questionable, given its prevailing parameters and the coexistence of a defined-contribution private pension fund system.

By the end of the 1990s, fiscal sustainability in Colombia was uncertain. The ratio of central government debt to GDP was rising fast, and several local governments were over-indebted. The external shocks...