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For many decades, fiscal policy in Latin America has amplified economic fluctuations—governments tightened the purse strings during recessions and increased spending during booms. This is in marked contrast to advanced economies, where fiscal policy has typically smoothed the cycle, by stimulating activity during recessions and withdrawing stimulus during booms, or at least remained neutral.
But in recent years, there are some encouraging signs that Latin American countries have started to reverse this trend, with fiscal responses playing a more stabilizing role. In fact, some countries were able to use fiscal stimulus during the global financial crisis.
Is this trend here to stay? And is it a good thing? Our latest Regional Economic Outlook for the Western Hemisphere looks at the relationship between fiscal policy and the economic cycle in Latin America as a whole and for individual countries. See also Klemm (2014)1 for a more technical analysis.
A history of boom and bust
Latin America has experienced a lot of economic ups and downs over the past few decades. External factors, notably swings in global financial conditions and commodity prices, have often been important. But domestic policy has also played a role. Fiscal policy, in particular, has historically added to economic volatility rather than reducing it. This is because the easy access to funds during periods of economic expansion often led governments to increase spending, adding fuel to the fire and causing economies to overheat. Conversely, when economies fell into recession or faced a sudden stop of capital inflows, governments generally had to cut spending and/or raise taxes, worsening the downturn (Figure 1).
Figure 1: Stylized public expenditure patterns over the business cycle
Signs of improvement
Our regression results confirm that fiscal policy in Latin America over the past decades has been, on average, procyclical—meaning expansionary in booms and contractionary in recessions. However, these results are averages across countries and time periods, so our study digs deeper and looks at what individual governments have done at different points in time.
Using country-level data, we find in most cases statistically insignificant results—a finding that can be easily explained by the small number of usable observations, yet is rarely acknowledged in the literature. It means that we cannot conclude for certain how a specific country’s fiscal policy behaved over the economic cycle.
Even so, when we look at the direction of change in fiscal policy (we analyze policy before and after 2005), we find some evidence that Brazil, Chile, Colombia, El Salvador, and Mexico have moved toward a fiscal policy that is less procyclical—in other words, that is less likely to add to economic volatility than before.
But challenges remain
Will this move toward more stabilizing fiscal policy last? The true test for countercyclical policy always comes when economies have fully recovered and it is time to withdraw the earlier stimulus—something governments in Latin America have so far shown little urge to do. Indeed, it can be politically very difficult to tighten the fiscal stance, even at times of record-low unemployment, when there are still important unfulfilled social needs.
And yet, without stronger fiscal positions during good times, it will be hard to repeat an effective stimulus in the next recession, not least because many Latin American countries still have high public debt (Figure 2). This underscores that public finances have to be in generally good health to allow for countercyclical policy.
Figure 2: Public Debt in Latin America (percent of GDP)
In the same vein, while fiscal stimulus in a downturn can be helpful, it has to be reversible or limited in time. If higher expenditures are structural in nature, such as the recruitment of permanent public servants, it will be much harder to readjust the policy stance once the economy recovers.
How actively fiscal policy should be used to smooth economic cycles remains controversial. It is pretty clear though that procyclical policy should be avoided. Stronger fiscal balances in good times would then create room for stimulus, or at least avoid the need for contractionary policy, when negative economic shocks hit.
To continue on the path of stabilizing fiscal policy, some countries should also consider structural changes. Fiscal rules, for example, can help, especially if they are designed to smooth fiscal balances over the cycle. The key, however, is to have enough foresight to see that today’s prudence will protect tomorrow's prosperity.
The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management
1. “Fiscal Policy in Latin America Over the Cycle”, IMF Working Paper No. 14/59, 2014.