Macroeconomic Regimes, Policies, and Outcomes in the World Klaus Schmidt-Hebbel Sociedad de Economía de Chile

Presidential Address, SECHI Annual Meetings Reñaca (Chile), September 4, 2008

I. Introduction

Main Research Questions 1.

Which structural and performance-related variables determine the adoption of macroeconomic regimes, i.e., monetary regimes (money, inflation, and ER targets), ER regimes, and fiscal regimes)?

2. What determines the success of macroeconomic policies in their counter-cyclical role and of monetary policy in attaining inflation targets? 3. Which structural and policy-related variables determines macroeconomic performance, i.e. growth, growth volatility, and inflation?

This Project There is a significant but partial previous empirical literature, often with ambiguous results This project: • revisits and extends previous hypotheses on determinants of regimes, policies, and outcomes, • subjects hypotheses to empirical scrutiny for the largest possible world data base (max 1970-2005, 98 countries), • using a battery of frontier panel-data models.

Macroeconomic Regimes, Policies, and Outcomes: Dependent Variables

*Project papers marked with

II. Project Papers

Project Papers On Macroeconomic Regimes (5 papers) 1. C. Calderón and K. Schmidt-Hebbel: “What drives the Choice of Inflation Targets in the World”, Central Bank of Chile. Manuscript, March 2008. 2. C. Calderón and K. Schmidt-Hebbel: “What drives the Choice of Moneybased Targets in the World”, Central Bank of Chile Working Paper No. 479, August 2008 3. C. Calderón and K. Schmidt-Hebbel: “Choosing an Exchange Rate Regime”, Central Bank of Chile. Manuscript, March 2008. 4. C. Calderón and K. Schmidt-Hebbel: “The Choice of Fiscal Regimes in the World”, Central Bank of Chile. Manuscript, March 2008. 5. G. Leyva: “The Choice of Inflation Targeting” Central Bank of Chile Working Paper No. 475, July 2008

Project Papers On Macroeconomic Policies (5 papers) 1. C. Calderón and K. Schmidt-Hebbel: “Macroeconomic Policies and Performance in Latin America”, Journal of International Money and Finance, 22 (7): 895-923, 2003. 2. C. Calderón, R. Duncan, and K. Schmidt-Hebbel: “The Role of Credibility on the Cyclical Properties of Macroeconomic Policies in Emerging Economies”, Review of World Economics, 140 (4): 613-33, 2004. 3. C. Calderón and K. Schmidt-Hebbel: “Business Cycles and Fiscal Policies: The Role of Institutions and Financial Markets”, Central Bank of Chile Working Paper 481, August 2008. 4. E. Albagli and K. Schmidt-Hebbel: “Does Credibility Help in Meeting Inflation Targets?”, Central Bank of Chile. Manuscript, March 2008. 5. E. Albagli and K. Schmidt-Hebbel: “By How Much and Why do Inflation Targeters Miss Their Targets”, Central Bank of Chile. Manuscript, March 2008.

Project Papers On Macroeconomic Performance (5 papers) 1. C. Calderón, N. Loayza, and K. Schmidt-Hebbel: “External Conditions and Growth Performance”, in R. J. Caballero, C. Calderón, and L. F. Céspedes (editors): External Vulnerability and Preventive Policies. Central Bank of Chile, 2006. 2. C. Calderón, N. Loayza, and K. Schmidt-Hebbel: “Does Openness Imply Greater Vulnerability?”, Central Bank of Chile. Manuscript, March 2008. 3. Calderón and K. Schmidt-Hebbel: “Openness and Growth Volatility”, Central Bank of Chile. Manuscript, March 2008. 4. I. Elbadawi, L. Kaltani, and K. Schmidt-Hebbel: “Foreign Aid, the Real Exchange Rate, and Economic Growth in the Aftermath of Civil Wars”, The World Bank Economic Review, 22 (1): 113-140. 2008 5. Calderón and K. Schmidt-Hebbel: “What drives Inflation in the World”, Central Bank of Chile. Manuscript, March 2008.

Words of Appreciation Co-authors: - Elias Albagli (Harvard University) - César Calderón (Word Bank) - Roberto Duncan (University of Wisconsin) - Ibrahim Elbadawi (World Bank) - Linda Kaltani (International Monetary Fund) - Norman Loayza (World Bank)

Research Assistants: - Mauricio Calani (Central Bank of Chile) - Gustavo Leyva (Central Bank of Chile) - Marcelo Ochoa (Duke University)

Fondecyt 2007-2009 Research Project No. 1060175

III. Estimation Methods and Data

General Panel Data Model for Macroeconomic Regimes, Outcomes, and Performance

yi,t = y(i,t−1)' a + xi,t' β + zi,t' δ + (xi,t,kzi,t,q )'γ + ui + vt + εi,t y i,t =

dependent variable for macroeconomic regimes, policy outcomes or performance measures

xi,t =

(Kx1) vector of exogenous variables

zi,t =

(Qx1) vector of exogenous variables

ui = vt = εi,t =

country effect (country dummy) time effect (time dummy) error term

Panel-data Estimation Methods

A Word about Two Estimation Methods Conditional Logit Estimator - Applies only to countries that are movers -- i.e., to countries whose decision varies along the time sample - No-movers (stayers) are excluded from estimations.

Pooled Mean Group Estimator - Allows for short-run behavior heterogeneity but imposes longrun homogeneity

Samples and Main Data Sources

IV. Selective Figures

0

5

Number of countries 10 15 20

25

Money-based (MT) and Inflation (IT) Targeting Regimes, 1975-2005

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

MT regime

IT regime

0

20

Number of countries 40 60

80

100

Flexible and Non-flexible Exchange-rate Regimes, 1975-2005

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

flexible

non-flexible

0

Number of countries 10 20

30

Fiscal Regimes, 1975-2005

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Countries with Fiscal Rules

0

Trade Openness (%): (X+M)/GDP 1 2 3 4

5

Trade Openness in the World, 1975-2005

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Financial Integration (%): (Assets+Liabilities)/GDP 0 5 10 15

Financial Integration in the World, 1975-2004

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

-2

Financial Openness (normal index) -1 0 1 2

3

Financial Openness in the World, 1975-2005

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Inflation Deviations, 1989-2004: ITers vs. NIters 3

NITers ITers 2.5

2

1.5

1

0.5

0 1989q1 1990q3 1992q1 1993q3 1995q1 1996q3 1998q1 1999q3 2001q1 2002q3 2004q1

-.5

Normalized Inflation Rate 0 .5

1

Normalized Inflation in the World, 1975-2005

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

-.4

-.2

GDP growth 0

.2

.4

GDP Growth in the World, 1975-2005

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

V. Selective Results

V.1 Selective Results: Macro Regime Choices

1. What drives the Choice of Inflation Targeting Regimes in the World? Significant and robust determinants of the likelihood of having in place an IT regime: 1. 2. 3. 4. 5. 6. 7.

Inflation (-) Fiscal position (+) Financial development (+) Exchange-rate regime (-) GDP per capita (+) Trade openness (+) Regional dummy for Latin America (+)

Robustness results across specifications

2. What drives the Choice of Money-based Targeting Regimes in the World? Significant and robust determinants of the likelihood of having in place a MT regime: 1. 2. 3. 4.

Financial development (-) Money demand instability (-) Government fiscal balance (-) Trade openness (-)

Robustness Results across Methods

Robustness Results across Country Samples

Robustness Results across Time Samples

3. What drives the Choice of Exchange Rate Regimes in the World? Significant and robust determinants of the likelihood of having in place a flexible ER regime: 1. OCA variables: 1. 2. 3. 4.

Trade openness (+) Country size (-) GDP per capita (+) Terms of trade volatility (+)

2. Macroeconomic conditions: 1. 2. 3.

Current account surplus (-) Real exchange rate misalignment (-) Inflation (+)

3. Financial-market openness and depth: 1. 2.

Financial openness (-) Financial development (-)

4. What drives the Choice of Fiscal Regimes in the World? Significant and robust determinants of the likelihood of having in place a fiscal regime (based on rules): 1. 2. 3. 4. 5.

Government budget balance (+) Dependency ratio (-) Fiscal expenditure procyclicality (-) Government stability (+) GDP per capita (+)

Robustness Results across Specifications

V.2 Selective Results: Macro Policy Outcomes

1&2. What drives the Cyclicality of Fiscal and Monetary Policies in EMEs? Significant and robust results: Fiscal and monetary policies are counter-cyclical (pro-cyclical) in emerging market economies with: – low to moderate (high) country-risk spreads – high (low) levels of governance

Cyclical Behavior of Macro Policies

Response of Macro Policy to Output Gap

1.0 0.8 0.6 0.4 0.2 0.0 34 36 37 39 41 42 44 45 47 48 50 52 53 55 56 58 59 61 62 64 66 67 69 70 72 73 75 77 78 80 81 -0.2 -0.4 -0.6 -0.8 -1.0 Index of Governance, ICRG

Fiscal Policy

Monetary Policy

3. Fiscal Policy Cyclicality: The Role of Institutions and Financial Markets Main robust results: 1. Budget balances are counter-cyclical (pro-cyclical) in industrial economies (developing countries) 2. Political distortions and market failures explain the procyclical bias of fiscal policies in many developing countries 3. The factors that explain the cyclical behavior of budget balances are the following (in order of importance): institutional maturity, financial openness, and financial depth.

Interaction between Cycles and Financial Development / Political Institutions in determining Budget Balance Cyclicality Response of budget balance to 1 s.d. increase in output (world sample) Full Sample of Countries 1.1. Conditional on the degree of financial openness

1.2. Conditional on the level of financial development

0.03

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0.02

0.03

0.01

0.02

0.00 -0.01 0

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-0.02

-0.05

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-0.06 -0.07

-0.04 Foreign Liabilities (% of GDP)

Domestic credit to the private sector (% of GDP)

1.3. Conditional on the level of institutions

1.4. Conditional on the political regime

0.08

0.04

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0.00 -0.02 0

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-0.06

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-0.01

-0.08 -0.10

-0.02 ICRG Index of Political Risk

Polity Score

2

4

6

Interaction between Cycles and Financial Development / Political Institutions in determining Government Expenditure Cyclicality Response of government expenditure to 1 s.d. increase in output (world sample) Full Sample of Countries 4.1. Conditional on the degree of financial openness

4.2. Conditional on the level of financial development

0.40

0.25

0.35

0.20

0.30

0.15

0.25 0.20

0.10

0.15

0.05

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0.00

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0.00 -0.05 0

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-0.10

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-0.10 -0.15

Foreign Liabilities (% of GDP)

Domestic credit to the private sector (% of GDP)

4.3. Conditional on the level of institutions

4.4. Conditional on the political regime 0.15

0.50 0.40

0.10

0.30

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0.20 0.10

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-0.10 0

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-0.20 ICRG Index of Political Risk

Polity Score

70

80

Explaining Differences in Fiscal Cyclicality: Industrial vs. Developing Economies 8.1. Budget balance

8.2. Government expenditure

1.0

1.0

0.8

0.8

0.6

0.6

0.4

0.4

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0.0

0.0

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-0.4 Developing

AMER

Financial openness

EAP

ECA

Financial development

MENA Institutions

SA

SSA

Developing

Political regime

8.3. Current expenditure

AMER

Financial openness

EAP

ECA

Financial development

MENA Institutions

SA

SSA

Political regime

8.4. Capital expenditure

1.0

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-0.4 Developing

AMER

Financial openness

EAP

ECA

Financial development

MENA Institutions

SA

SSA

Political regime

Developing

AMER

Financial openness

EAP

ECA

Financial development

MENA Institutions

SA

SSA

Political regime

1&2&4&5. What determines Absolute Deviations of Inflation from Inflation Targets in IT Countries? Significant and robust determinants: Credibility measures: 1. 2. 3.

Central Bank formal independence dummy (-) External sovereign debt spreads (-) Institutional investor’s country risk rating (-)

V.3 Selective Results: Macro Performance

1. How do External Conditions affect Growth Performance in the World? Main robust results: 1. Trade openness (+) 2. Financial openness (+) 3. Growth effects of trade and financial openness are significant for middle and high-income countries 4. Larger trade openness dampens the growth effects of trade-related shocks while amplifying the effect of financial market shocks. 5. However, larger financial openness amplifies the growth effects of trade-related shocks while attenuating the impact of regional capital inflows.

2&3. What determines Growth Volatility? Main robust results: 1. Trade openness (+) 2. Financial openness (+) 3. Trade openness exacerbates sensitivity to external volatility whereas financial openness reduces tye latter sensitivity 4. Trade opening increases the impact of interest rate shocks, while financial opening reduces the effect of capital inflow shocks

5. What drives Inflation in the World? Significant and robust determinants that reduce inflation in the world: 1. 2. 3. 4. 5. 6.

Inflation targeting regime (+) Fixed exchange-rate regime (+) Financial openness (+) Fiscal balance (surplus) (+) Income per capita (+) Output gap (-)

VI. Afterthoughts on Methods, Inference, and Policy Implications

Methods and Inference •

This project confirms that identification in empirical macroeconomics is difficult due to: – – –

–

•

existence of competing hypotheses, with many candidate variables reflecting a particular hypothesis, strong correlations across time and space observed among most variables (countries learn about macro regimes and policies over time and from each other; good-performing countries perform well in all dimensions), and (obviously!) inescapable endogeneity of RHS variables

Hence great caution should be exercized when doing empirical and policy inference.

Macro Regimes: the End of History? •

Best current practice on macro regimes in the world: – – –

full financial and trade openness exchange-rate flexibility cum inflation targeting or giving up domestic currency Fiscal rules

•

Many countries are far from the best current practice

•

“Optimal” macroeconomic policy regimes come and go – it’s certainly not yet the end of macro history

Policy Inference for Chile •

Chile is certainly at (and contributing to push forward) the international frontier of macro regimes and policies: – – –

•

very large degrees of financial and trade integration dirty ER float cum clean inflation targeting highly original fiscal rule, based on structural fiscal surplus

Yet there are major challenges to improve: – – – –

international trade and capital-market integration ER interventions and optimal level of international reserves inflation targeting regime operation of structural fiscal policy and optimal level of reserves in sovereign wealth funds.