My topic today is the “fiscal regime”, that is, the set of principles and rules that guide the management of fiscal policy. While the Fiscal Responsibility Law of 2000, the Brazilian regime worked reasonably well. Unfortunately the LRF didn’t catch on — it was run over in 2014 and passed away.
The country’s fiscal health has remained fragile since then. While meritorious, the brief attempt to replace the LRF with a cap on spending growth has recently watered down. The combination of recurrent fiscal deficits and high public debt represents a serious source of risk, which pressures interest rates and inhibits the country’s growth.
I present below elements for the construction of a new fiscal regime for Brazil, with a focus on macroeconomic aspects. I start with a brief review of concepts.
When expenditures exceed revenues, the government is forced to borrow (from the private sector or from outside lenders) to cover the difference (the deficit). The ability of a government to get into debt is finite and depends on the interest rate that its creditors demand for not opting for other uses of its resources, such as investing in other assets, consuming or taking the money out of the country.
All the more constant, the greater the indebtedness, the higher the interest the government pays. A country’s debt capacity also depends on the size of its economy and its growth. A growing country may become more indebted than a non-growing one, as it will have more resources in the future to service the debt (and therefore, it will be easier to roll over the debt).
Primary deficit is what is obtained when interest payments are excluded from the public deficit. It is the variable that the Treasury controls. When analyzing fiscal issues, it is natural to look at data as a proportion of the country’s GDP. Debt growth as a proportion of GDP depends on the growth of the numerator (public deficit) and the denominator (GDP). For example: with primary equilibrium, debt as a proportion of GDP will grow if the real interest rate is higher than the GDP growth rate. With a primary deficit, it will grow even more.
We can now list four basic pillars for the Brazilian fiscal regime (variables always as a proportion of GDP).
1. The public debt must be of such size that, in case of need, such as a recession or pandemic, it is possible to finance a policy of fiscal expansion without difficulty.
2. The primary result must be such that, in normal times, public debt remains stable at the desired level.
3. The primary result must be recalibrated in order to gradually bring the debt back to the desired level after fiscal expansions. In other words: after an expansionist period, fiscal policy should become contractionary.
4. The maturities of debt maturities must be long, with no concentration on the short term. This reduces the likelihood of financial and exchange crises caused by contractions in the supply of finance.
The definition of goals 1 and 2 is quite subjective, as it depends on a wide range of factors, of an economic, political and historical nature. The interest rate the government pays its creditors and the average term of its debt are good indicators. In this context of uncertainty, it seems clear to me that the reaction function implicit in the third pillar is the most relevant aspect of the regime. It is crucial for macroeconomic stability.
Targets for primary and debt should be reviewed periodically (every five years or more). Institutionally stable countries, with a good economic history, typically finance themselves at low interest rates and long terms. Therefore, they can live with bigger debts and more slack in the primary. This is clearly not our case.
It has been our fate to have to cut spending and raise interest rates and taxes in times of difficulty, instead of pursuing an expansionist, therefore countercyclical, policy. The reason is simple: the offer of credit to the government tends to dry up in times of suffocation. This is due to the absence of a robust fiscal regime and our history of defaults, crises and inflation, which do not inspire confidence.
The current picture is once again dangerous. The primary balance has been negative for years. Growth has been low for decades and interest rates are high. In this context, a debt of 80% of GDP is high. The daily reading of the newspapers leaves no doubt: the fiscal regime we had was being mutilated and crumbled. We are facing a trap. Interest rate voluntarism is a suicidal recipe, we all know. It should come as no surprise that the cost of government funding is soaring. For ten years, it’s about 6 percentage points a year higher than the US in real terms, and 9 points higher for non-inflation-linked bonds. It is not a sustainable framework.
In this space, I have discussed the opportunities available to implement a new fiscal regime based on the above principles. It wouldn’t be easy, but the impact would be surprising and would be felt quickly. In conjunction with other reforms, it would make a long development cycle possible, such as we have not experienced in Brazil for a long time. In any case, without a robust fiscal regime, we are bound to see the economy get even worse.
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