Democracy Lab

Chile's Countercyclical Triumph

Though politicians love to talk about saving for a rainy day, not many have actually managed to pull it off. How Chile bucked the trend.

The news from Chile these days is dominated by the sagging popularity of conservative President Sebastian Piñera. But just four years ago, Chile was equally turned off by Piñera left-center predecessor, Michele Bachelet (above) -- though for completely different reasons.

Bachelet's low approval ratings in 2008 were largely due to her refusal to spend soaring government receipts from copper exports. The world price of copper -- Chile's largest export -- hit $800 per metric ton that year, an historic high in nominal terms and more than quadruple the level of 2001. Yet her government insisted on saving most of the proceeds for a rainy day.

What a difference a few years could make: By the time they completed their term in early 2010, Bachelet and her finance minister, Andrés Velasco, enjoyed the highest approval ratings of any president and cabinet minister since the return of democracy to Chile.

That reversal can't be attributed to the fortunes of the Chilean economy. Quite the contrary: At the time, Chile was bearing the brunt of the global recession. In 2009, the price of copper fell abruptly, growth turned negative, and unemployment topped 10 percent. But the government was able to respond with sharply increased spending to cushion the blow and speed the recovery, drawing down revenues that had accumulated while the world couldn't get enough Chilean copper. Now that the rainy day had come, Bachelet and Velasco were viewed as heroes.

The significance of this episode is not that an especially wise or brave policy prescription can make a very big difference; it can, but the idea of saving in a boom in order to be able to spend in the bust is not new. And while action to this end is less common than the words, there are certainly examples of governments that have shown the courage to put away the fiscal punch bowl before the crowd had drunk its fill.

What the world needs -- and, ironically, what was delivered by Chile rather than by a mature industrialized economy -- is institutions designed to produce good policies even when the officials charged with carrying them out are vulnerable to wishful thinking or inclined toward expediency. Indeed, Chile's handling of the copper-price roller coaster could serve as a template for other countries in which the political pressures to follow "pro-cyclical" fiscal policies are very hard to resist.

The restraint on Chile's fiscal policy is codified in law. The government must announce a budget target -- originally set at a surplus of one percent of GDP, but softened to zero (i.e., budget balance) in 2009. That sounds a lot like the eurozone's Stability and Growth Pact, which was supposed to limit member-states' deficits to three percent of GDP. But unlike Chile's budget rule, the SGP was born to fail. As everyone knows by now, the fiscal limits were repeatedly violated by members large and small.

The flaw in the original SGP was its rigidity. It didn't allow "countercyclical" fiscal policy -- that is, policies that offset the changing tides of private demand. It did not even permit budget deficits to rise if the cause was declining tax revenues in recessions.

Chile's rule beats the one-size-fits-all trap by targeting the structural budget deficit, defining the acceptable deficit by what it would have been in more normal times. In a boom, the government can thus spend the increased revenues if and only if the boom is structural -- that is, permanent. If the bonanza is cyclical (and thus temporary), the revenues must be saved.

But there's another flaw here, even with rules keyed to structural deficits: Who is to forecast economic growth? Who is to determine (in real time) what is structural and what is cyclical? Politicians can always attribute an excessive budget deficit to temporarily disappointing economic growth and duck the issue of reducing it -- if they're lucky, until they leave office.

Chile's structural balance regime limits the loopholes by specifying that the government may run a deficit larger than the target only to the extent that output falls short of its long-run trend, or the price of copper is below its medium-term (10-year) equilibrium. And crucially, those numbers are not left to politicians to calculate. In the middle of each year, panels of independent experts estimate them. The government then follows prescribed procedures to translate the numbers into the structural budget balance.

I've studied official government forecasts of economic growth rates and budgets in 33 countries. On average, there is a significant bias toward optimism, which is stronger during economic upswings: growth apparently leads officials to conclude that good times will go on rolling indefinitely. This finding explains why so many governments fail to repair the holes in their roofs while the sun is shining.

More surprisingly in light of economists' love affair with rules, the bias toward smiley faces is stronger for countries that have SGP-type rules than for those that do not. When a country's budget deficit exceeds the rigid target, officials find it expedient to forecast that things will get better next year.

Nobody in Chile claims that the forecasts of experts are accurate. But they are far less likely to be systematically biased than those cooked up by politicians. Indeed, unlike the rest of the 33 countries, Chile has managed to produce forecasts that have not been biased toward optimism since 2000.

Part of the credit for Chile's structural budget rule should go to the government of President Ricardo Lagos (2000-2006) and his finance minister, Nicolas Eyzaguirre. They opted for the structural budget benchmark, and delegated the calculations to experts. The payoff, in the form of budget surpluses in good times, was immediate. Between 2000 and 2005, public savings -- that is, the difference between revenues and expenditures rose from 2.5 percent of GDP to 7.9 percent.

But in this first phase, the budget rule was not a formal mandate, and thus might well have been violated in a crunch. The newly elected Bachelet government enshrined the general framework in law in 2006. Global credit markets got the message: In December of that year, Chile was awarded a sovereign debt rating of A, several notches ahead of Mexico, Brazil, and other Latin American peers.

The copper boom provided the real test of the Bachelet administration's determination to play by the rules. Bachelet was pressed hard to declare that the increase in the price of copper was permanent, thereby justifying increased spending in good times. But the expert panel ruled that most of the price increase was temporary, so most of the earnings had to be saved. And to its credit, the government supported the finding.

As a result, the fiscal surplus reached almost nine percent of GDP during the boom. Chile used the surplus to pay down its debt to a mere four percent of GDP and was still able to sock away a sum equal to about 12 percent of GDP in its sovereign wealth fund. The country's credit rating climbed to A+, the same as Japan's.

Which brings us back to the beginning of our story: The rainy-day fund was there to be spent in the recession of 2008-09, when stimulus was sorely needed. In short, Chile managed what policymakers in most developing countries have only dreamed about: A truly countercyclical fiscal policy.

There's no compelling reason why a version of Chile's structural budgeting institutions couldn't be emulated by other developing countries that are dependent on the vagaries of commodity prices. The whole point, after all, is to design a system to work in an environment in which politicians are as prone to myopia as teenagers.

The Chilean approach could be improved even further by making it illegal to fire members of the expert panels. It is also worth thinking about making the structurally adjusted targets actively (as opposed to passively) countercyclical. Bachelet and Velasco were able to save more than required in the 2007-08 boom, allowing them to run a bigger deficit than the law required in the 2009 recession. Why not try to build that more aggressive approach into the budgeting formula?

While we're at it, why limit the Chilean approach to developing countries? Last time I looked, budget discipline comes easy exactly nowhere.



The Fast and the Ridiculous

The conspiracy theories over the controversial ATF gun-tracking program are flying, and not just in GOP chambers. In Mexico, it's taken as fact that the United States is backing the drug cartels.

The majority members of the U.S. House Oversight Committee have been granted their fondest wish -- their investigation into Operation Fast and Furious has caused the biggest proto-scandal in Washington, thanks to Attorney General Eric Holder's refusal to hand over documents and a House panel's vote last week to recommend the chamber cite him with contempt. No longer the private obsession of the right-wing media, Fast and Furious is on front pages and leading news broadcasts around the United States.

At issue now are two questions. First, what was the exact intent and oversight of the operation, run out of the Phoenix office of the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF)? The agency says it was meant to track illicit guns going over the border into Mexico, as part of an effort to build cases against major smugglers. Where cross-border gunrunning is concerned, ATF is usually confined to interdicting low-level purchasers, thanks to crippling investigative limits put on it by Congress.

Fast and Furious evolved out of a larger initiative, Project Gunrunner, an ambitious plan to extend the ATF's investigative reach into Mexico and put the agency on more equal footing with the Drug Enforcement Administration (DEA), which leads the war on drugs and has informants embedded deep in the cartels. The controversial tactic of allowing guns to "walk" in order to see where they go, the central issue in the investigation, began late in George W. Bush's administration and was carried over into President Barack Obama's term. Between 2009 and 2011, the ATF lost track of thousands of guns, according to certain agents. Some reached criminal gangs in Mexico (which was the point), including two that were found at the scene of a 2010 shootout where Brian Terry, a U.S. Border Patrol agent, was killed. Others have appeared at crime scenes around Mexico.

The second question, which has pushed the ATF into the background, is what the attorney general is refusing to show the House Oversight Committee. While Holder has turned over 7,600 documents, as he never fails to remind the committee, he won't release memos and emails that committee members believe detail Justice Department debates about how to handle the Fast and Furious fallout. Committee Chairman Darrell Issa and other congressional Republicans make it no secret that they think Holder is running a coverup. They were more coy about suspicions that Obama is privy to it, but his decision last week to exert executive privilege on Holder's behalf has put an end to that.

Longtime critics of the ATF, from a libertarian banker I recently dined with to National Rifle Association director Wayne LaPierre, claim to believe the corruption runs much deeper. They say Fast and Furious proves the agency has been funneling guns to Mexican criminal organizations. Why the ATF would be doing this -- and making official policy of it -- is never part of the argument. Nonetheless, it's a short leap from that rock over the stream of reason and onto the one where Obama is actively working with Mexican cartels -- a belief that many Americans hold (just Google it).

While that sounds preposterous to most of us, including (one assumes) to most critics of the president, there is a place where the levelheaded believe what the anti-government fringe in the United States believes, and where Fast and Furious is a constant topic of conversation -- Mexico. Issa's investigation is a mainstay of news coverage there. Go on the comment boards of Mexican newspapers such as La Prensa or magazines such as Proceso, and you'll find that readers mention Fast and Furious, in conspiratorial tones, at every chance.

This spring, I was in Culiacán, home to the Sinaloa cartel and some of the worst recent violence in Mexico. Beginning in 2007, just as Project Gunrunner was getting started, the cartel's leader, Joaquín "El Chapo" Guzmán Loera, was challenged for supremacy by a gang from the east, Los Zetas, and by the Beltrán-Leyvas, a quartet of murderous brothers who had once worked for Chapo. Gun battles broke out in the plazas and streets of Culiacán on a daily basis. Heads rolled, literally, a lot of them.

When I was there, the situation had stabilized somewhat -- the Beltrán-Leyvas had been mostly defeated, and the Zetas had been pushed to Sinaloa's smaller cities -- but it was still, by any sane standards, insane. On my second night in town, 12 bodies belonging to an amateurish crew of pistoleros were found around town. Later, a police captain and his brother were gunned down a few blocks from the central square.

I spent a week with the editors of Ríodoce, a Culiacán weekly that may be the best newspaper in Mexico right now. Certainly, it's among the bravest. While most news organizations have backed away from covering drug-trafficking and government corruption because so many journalists have been killed, Ríodoce goes after those stories with relish. It has made a favorite subject of Chapo. It would prefer to focus on politicians on the take, editor Ismael Bojórquez told me, but readers get disappointed when they don't see everyone's favorite bandito on the cover.

Bojórquez is as sapient as they come, and no conspiracy-theorizing pundit. His sources in government and the criminal underworld are extensive. He is also very prudent, a necessity when as many people want you dead as want him dead. Yet he takes it as a given that the ATF intentionally supplies the Sinaloa cartel with guns. U.S. agencies have long been in bed with the Sinaloans, he explained to me, and this scheme to move massive numbers of weapons into the country is more of the same. He noted that it coincides directly with the cartel wars of the late 2000s. Project Gunrunner and later Fast and Furious were, Bojórquez is sure, a way for America to arm Chapo, with whom it's in business. To him, this connection is as clear as day.

Bojórquez is not alone -- most Mexican journalists I speak with, and many average Mexicans, take Washington's collusion with the Sinaloa cartel for granted.

This interpretation of events owes partly to Chapo's reputation. A folk hero of mythic proportions, the man's very name has incantatory powers in Mexico. When it's uttered around Culiacán, it's usually in a whisper. Or people refer merely to "Him." Everyone knows who is meant. Mexicans tend to have very little faith in their government's abilities, aside from its ability to be corrupted -- and Chapo's competence in this regard is so obvious as to not need mentioning. Many Mexicans assume he essentially runs the country, and it's easy to see why. Since President Felipe Calderón took office in 2007, a steady procession of high-raking government, military, and police officials has been revealed to be working for Chapo or his deputy, Ismael "El Mayo" Zambada.

The interpretation owes partly to a contempt for and fear of American power and arrogance that go back to the 19th century. An editorial in La Prensa last year cast Fast and Furious as the latest attempt at Manifest Destiny. The reasoning may have been off, but the sentiment was understandable: Americans do, after all, smoke, snort, swallow, and shoot up the great majority of drugs produced or moved through Mexico, and Americans export almost all the guns used in the murders there, with or without the help of the ATF.

Then there's the long collusion between the U.S. government and drug-trafficking organizations, as Mexican students of history are quick to point out. Aside from the CIA's machinations in neighboring Central America, they refer to the U.S. Army's reliance on Sinaloan poppy-growers during World War II to keep up morphine supplies. More recently, the New York Times detailed the DEA's program for laundering and moving money for Mexican traffickers in order to trace where it goes (like Fast and Furious, but with bills, not guns). In a case going on in Chicago, El Mayo's son, Jesús Zambada Niebla, who was extradited to the United States in 2010, has claimed that he is immune to prosecution because he was working with the DEA. Court documents show that he did in fact take a meeting with agents, who claim no agreement was reached. The documents also show that, for years, the DEA has relied on a Mexican lawyer high up in Chapo's organization for information. Last year, the Mexican Senate called on former Attorney General Eduardo Medina-Mora -- who was seen as ineffective and was replaced after losing the confidence of U.S. officials, the Los Angeles Times reported -- to answer questions about what he knew of Fast and Furious. (Despite  briefing notes subpoeaned by Issa that suggest Bush-era U.S. Attorney General Michael Mukasey kept his Mexican counterpart abreast of ATF operations, Medina-Mora has repeatedly denied knowing about the operation.)*

Revelations like these, combined with the failure of the Mexican government to capture Chapo and El Mayo, lead people like Bojórquez to the same conclusion: The Sinaloa cartel cut a deal with Calderón when he came into office, whereby it would help Mexico City go after other cartels, such as the Zetas, in exchange for some amount of immunity. Calderón could only have done this, the argument goes, with high-level approval from Washington -- and Fast and Furious, a way to help Chapo, is evidence of that devil's bargain. (When one points out that many members of the Sinaloa cartel, including some alleged favorites of Chapo, have been captured recently, a common answer is that Chapo simply gave them up like pawns. His mastery knows no limits.)

The holes in this line of reasoning are numerous, but there's history behind it. As former DEA chief Robert Bonner wrote in Foreign Affairs recently, this resembles the approach his agency took against Colombia's Medellín cartel in the 1990s. And Bonner recommends it for Mexico.

Whatever the ATF's arrangements, one thing that is clear is that it handled Fast and Furious incompetently. And as anyone who has reported from Mexico knows, the line between incompetence and corruption is often too thin to discern. Indeed, when it comes to death -- by Mexico's own conservative tally, there have been close to 50,000 killings related to criminal organizations and drug-trafficking since Calderón took office -- the line is tragically irrelevant.

It's not only the Mexican media that is convinced of the ATF's corruption. The country's Senate has agreed to back the extradition of U.S. officials involved in Fast and Furious (a symbolic gesture, but telling), and lawyers are preparing class action lawsuits against the United States on behalf of the families of people killed with guns smuggled south across the border.

In the meantime, U.S. Rep. Issa has become something of a hero in Mexico, though the irony of this is lost on most Mexicans -- he was a supporter of California's Proposition 187, which attempted to deny noncitizens basic government services. Since the 1990s, Issa has opposed comprehensive immigration reform and joined the Immigration Reform Caucus, a hard-line enforcement group founded by nativist barnstormer Tom Tancredo. And -- Holder might mention this the next time he goes before the chairman -- Issa was once arrested for illegal gun possession.

It seems unlikely that Issa will get the documents he wants from the Justice Department before the November elections, even with his impressive network of leakers. If he does get them and they suggest an effort on Holder's part to obstruct the investigation, the consequences for Obama could be serious (though not Watergate-serious, no matter how desperately conservative commentators push that analogy). Confirmation of Zambada-Niebla's claims could be nettlesome, too, were anybody paying attention to that case and cared to make hay of it.

Mexico's upcoming July 1 presidential election offers an ironic comparison. Voters there are all but certain to elect Enrique Peña Nieto, the candidate of PRI, the political party that ran the country for most of the 20th century and whose coziness with criminal organizations is proverbial. Many Mexicans want PRI back in power not despite that reputation, but because of it. They are sick of the violence that has come with Calderón's efforts against the cartels and want peace, and if that means negotiating with the cartels, Sinaloa included, and allowing them to smuggle drugs to the United States, they say, so be it -- as long as the killing abates.

*Correction: The article misstated former Mexican Attorney General Eduardo Medina-Mora's position on his knowledge of the Fast and Furious operation. He has repeatedly denied knowledge or either formal or informal approval of Fast and Furious.

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