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Municipal money managers

Most of the world knows that Latin America has become a stronghold of democracy in the last decade, with all but one of the region's countries claiming freely elected governments and national legislatures.But few foreign observers understand the extent to which the democratic process has reached down into the region's local governments as well. After decades in which most local officials were hand-picked by remote federal governments as a form of political patronage, cities, towns and villages across the region are now asserting their right to elect--and hold accountable--their own leaders. "City Hall Is Becoming A New Power Center All Over Latin America," announced The Wall Street Journal recently in a front- page story. Indeed, while only three countries in Latin America elected their mayors by popular vote in 1980, 17 do so at present, while in seven other countries these officials are appointed by elected municipal councils.

This change is part of an unprecedented process of decentralization of authority that has paralleled the economic and political reforms adopted by most Latin American governments in the last decade. The abolition of controls on trade, production, and financing has restored decision-making independence to businesses and private individuals at the microeconomic level. Macroeconomic stabilization has successfully created an environment conducive to such decisions by helping to dispel inflation-related uncertainty while reducing financial and exchange rate instability.

As a result, political parties and voters have begun to reassert their right to determine how public resources are used to solve local and regional problems. Under pressure from voters, central governments have shown a growing willingness to decentralize tax and revenue mechanisms. This has placed unprecedented amounts of money in the hands of city and municipal governments, which have also accepted responsibility for delivering services such as education, health and sanitation, and for building and maintaining a wide range of local infrastructure projects.

FORMULA FOR DISASTER...?Not long ago, this pattern would have alarmed many economists, who have often argued that localized, collective decision-making tends to undermine fiscal discipline and create perverse incentives for the participants. In essence, the assumption is that local officials either squander resources in pursuit of short-term agendas or demand government money in the expectation that others will pick up the tab.

However, Latin America has shown signs that it can keep a firm grip on these tendencies, which are an inevitable by-product of any democratic system. In fact, public fiscal management and performance have been improving in most Latin American countries, even as governments decentralize and become more democratic. Many Latin American countries have fiscal deficits that are lower than the average among industrialized countries. How can this be explained?

The 1997 edition of the IDB report Economic and Social Progress in Latin America takes an in-depth look at this apparent contradiction. Based on case studies from several regional countries, the report concludes that the extent to which fiscal discipline is preserved in a politically decentralized environment depends on the manner in which the public decision-making process is organized.

More specifically, success depends on the rules and institutions that govern budget decisions and electoral systems, because such rules determine how societies handle the contentious process of allocating public resources. In a decentralized, democratic context this process faces four basic challenges.

First, budgetary institutions must sift through the divergent and frequently contradictory preferences of the electorate. Second, various societal interest groups have to be discouraged from trying to make everyone else foot the bill for their own particular "wish lists." Third, politicians and bureaucrats must not be allowed to twist the decision-making process in such a way as to benefit themselves at the expense of the commonweal. And finally, budget institutions must find ways to overcome short-term thinking in favor of credible commitments to pursuing policies with long-term benefits.

Each of these pressures, if unchecked, can undermine the credibility and equity of the resource-allocation process and lead to runaway fiscal deficits. Although there are many ways to control these tendencies, case studies in Latin America indicate that most successful approaches pair an emphasis on transparency in the budget-making process with a set of systematic safeguards against deficit spending.

THE PUBLIC AS WATCHDOG...Transparency can be improved at a basic level through rules that mandate public hearings and frequent disclosures of proposed budget plans. More fundamentally, however, the transparency of the budget process depends on the strength of local democratic institutions. Active civic groups, clear rules for the financing of elections and political parties, a free and competitive press and an independent judiciary are all crucial to exposing and thereby discouraging lobbying or corruption in the budget-making process. When local democracy is weak, important areas of public life escape social scrutiny, interest groups exert undue influence, and opportunities for deficit spending increase.

Transparency alone will not guarantee fiscal discipline, however. For that, most successful regional governments have instituted three broad kinds of safeguards in the form of spending rules.

Rules that prevent local governments from relying too much on central government tax revenues to finance local projects. Governments should tie such projects to locally collected revenue from taxes on property, gasoline, toll roads and similar sources.

Rules that ensure stability in local government revenues. Transfers of national tax revenues to local coffers should not be based on simple percentages of total revenues, since these are subject to periodic business cycle fluctuations that can lead to sudden drops and deficits. A better approach is to link national revenue transfers to cost reimbursements.

Finally, effective budget policies that place strict limits on local governments' ability to borrow funds. In the past, many subnational governments that were allowed to borrow overindebted themselves, on the assumption that the national government would bail them out in the event of a default.

Although most of the region's local governments are only beginning to develop expertise in the complex art of resource allocation, these twin emphases on greater transparency and stricter budget rules are resulting in impressive early results.

* The writer is the chief economist of the Inter-American Development Bank.

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