Voracity, volatility and growth

Volatility has adverse implications for economic development. This study provides evidence that inadequate institutions are an important source of macroeconomic volatility in developing countries. In contrast to other work on governance, this paper infers institutional qualities from the policy responses they produce, rather than from subjective political indicators or proxy variables. In particular, it examines whether developing country fiscal policies respond pro- or counter-cyclically to macroeconomic fluctuations. The fiscal policy responses of twenty-five developing economies reveal that, while fiscal policy in many developing economies is pro-cyclical, it is much more heterogenous than previously appreciated. Fiscal policies vary both across countries and over time. Exploiting this variation reveals that fiscal policy patterns match differences/changes in political institutions: fiscal policy responses of more open political systems suffer less from pro-cyclicality. There is no evidence of a major role for either borrowing constraints or greater exposure to larger exogenous shocks. Pro-cyclical responses are also associated with greater macroeconomic volatility. The link between political institutions, pro-cyclical fiscal policy and volatility suggests that more open institutions and better enforcement of property rights are important for reducing volatility in developing countries.