6.5.1. The causes of the pro-cyclical bias of the fiscal policy in Latin America

During the current cycle of shrinkage, only Chile and Venezuela –the latter, because of high oil prices– have been able to apply a fiscal policy relatively counter – cyclical. All the other countries had to adopt a marked pro-cyclical policy.

The case of Argentina is the most dramatic example. The reason for this behavior is a vicious cycle formed by the volatility of the product, the pro-cyclical response to fiscal policy and the reduced access to international markets. The pro-cyclical opinion of the fiscal policy may, in turn, be explained by a combination of bad public policies and a deficient budgetary institutionalism, as well as information problems in the international financial markets.

First, there is a serious problem of credibility for most LAC countries that intend an expansive fiscal policy during a boom period. Not only do most of them reach the end of the boom in a worse fiscal position, but there is also an obvious problem of temporal inconsistency: governments may borrow today and then choose not to pay during boom periods.

Indeed, most of them have not reduced their levels of indebtedness during past boom periods and there is no reason why a financier may expect that they do the next time. Almost any country in LAC – except Chile – has been able to achieve a surplus during periods of economic prosperity and few have reduced their indebtedness in these periods.

In this case, expansive policies during periods of economic contraction may be seen as indicators of an unsustainable phenomenon in the course time – a deficit bias – and be interpreted as a factor increasing the risk of not paying the debt. Under these conditions, the appropriate response of creditors is that of not financing an increase of deficit during a boom period, or making it at significant higher spreads. Thus, the core of the problem lies in the impossibility of maintaining a surplus during the good times.

In a period of economic boom, the main reason for the adoption a pro-cyclical policy, lies both on the political economy of the fiscal policy and the non existence of strong budgetary institutions. If it is difficult for a Minister of Finance to avoid a deficit –especially in periods of financing availability– it is even more difficult to maintain a too evident surplus through the habitual budgetary process.

There are strong pressures in any budgetary process to increase spending and political incentives are clearly aligned with the use of any potential surplus during prosperity.

These pressures may inhibit a Minister of Finance, responsible for implementing an explicit counter-cyclical policy (or simply let automatic stabilizers work) during contraction periods of activity, because once Pandora’s Box of discretional spending and deficit increases has been opened, this may not be easy to close. Besides, the markets will punish this decision, as they are unable to distinguish easily between a responsible counter-cyclical response and an open loosening of the fiscal policy.

Additionally, failures in the financial markets help the pro-cyclical nature of the fiscal policy, by financing deficit during the boom periods, thus exacerbating the tendency towards a deficit bias of the fiscal accounts.