The threat of fiscal dominance in Brazil

October 22, 2015

????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????Brazil’s inflation is approaching 10 percent and yet the central bank has opted not to raise interest rates in a meeting on Wednesday. Not only that, it pushed back its target to 2017.

For many, the bank is staying put and tolerating a little more inflation because of the recession, the worst in decades.

But it may be not that simple. In fact, some economists advocate abandoning conventional wisdom to understand Brazil’s crisis. They say the bank may have not raised interest rates from 14.25 percent, already one of the highest in the world, because that would have fueled inflation, instead of cooling it.

Call it a paradox — if you’re too young.

Economic researchers have another name for it, which older Brazilians (and today’s Argentinians) know quite well: fiscal dominance.

The basic conditions for such a scenario are both large public deficits and market unease over long-term debt solvency. Brazil checks both boxes.

Theoretically, if the central bank raises interest rates under that scenario, debt stability falls into question, the currency drops and inflation goes up instead of falling. The level of prices is determined by fiscal policy and the government’s ability to print money, not by monetary policy.

See how interest rates paid by the government have risen, as a percentage of GDP. The data are from Brazil’s central bank:


This is the stuff of past policy nightmare: any mistake, and inflation goes through the roof.

Olivier Blanchard, who just stepped down as the International Monetary Fund’s chief economist, studied fiscal dominance.

“In 2002, the level and the composition of public debt in Brazil, and the general level of risk aversion in world financial markets, were indeed such as to imply perverse effects of the interest rate on the exchange rate and on inflation.”

Monetary policy seems as ineffective to keep prices in check with higher rates now than it was to stimulate the economy a couple of years ago with rate cuts. The central bank chopped the Selic to a record low of 7.25 percent, and what it got was the deepest recession since 1990 and possibly the longest since the Great Depression.

Debate heated up about a month ago, and there has been no consensus on whether Brazil has gotten to that point again or if that is just a (perhaps empty) threat.

Increasingly, Brazil has become a laboratory for academics and economic nerds — and a worsening disaster for policymakers who have run out of time to solve the theoretical riddle.

For Tatiana Pinheiro, an economist with Santander Brasil, fiscal dominance is not out there yet. The reason is that the government continues to project a primary budget surplus for next year, albeit small.

“If that is the central bank’s assumption too, and it looks like it is, decisions on monetary policy are not yet constrained by fiscal policy.”

Samuel Pessoa, an economist with think tank Getulio Vargas Foundation, is more worried. For him, Brazil seemed to have engineered a more stable and normally-functioning economy, but repeated policy mistakes between 2009 and 2014 fueled debt and took the country “back to its past”, he wrote in a recent newspaper article.

Monica de Bolle, an economist with the Peterson Institute in Washington who launched the debate in late September, defends a temporary currency peg and even capital controls to help accommodate price rises while the government tries to sort out some new revenues. Brazil’s lauded inflation-targeting regime should be put to rest for some time, she says.

Prominent economists will meet next week in Sao Paulo to debate fiscal dominance, and articles and op-eds will probably continue to pop up. Consensus may take long to be formed. Believers and skeptics share one view, though: under fiscal dominance or not, the solution to Brazil’s crisis requires mending the budget. But politicians hold the key.

Bruno Rovai, an economist with Barclays, wrote in a report properly called “Political Labyrinth”:

“The situation likely has to become worse before it creates a more constructive political situation. This will leave Brazil’s outlook clouded for some time.”


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That time is fast approaching: 15/10/15/brazil-seems-eager-to-relive-th e-good-ole-days/

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How does a balanced budget get you 10% inflation?

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