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Brazil’s Argentina Moment

Last December, in a move to regain market confidence, Brazil’s National Congress adopted an unprecedented constitutional amendment that caps non-interest government expenditures for at least a decade. The move was born out of a real sense of fiscal urgency, but it carries significant long-term risks.

CAMBRIDGE – Brazil’s economy has been in free fall, a casualty of years of economic mismanagement and the vast corruption scandal that has engulfed the country’s political and business establishment – and which now threatens to bring down the second president in as many years. It may seem hard to focus on policy developments amid the political and economic turmoil, but the fact remains that Brazil must overcome fundamental challenges if it is to lay the groundwork for sustainable growth. Few loom as large as the country’s fiscal woes.

There is a strong argument that Brazil’s overstretched government finances have long held back the economy. At 36%, the ratio of government spending to GDP is one of the highest among countries at a similar income level. Years of fiscal laxity, mounting social security obligations, and low commodity prices have greatly magnified concerns – now compounded by the political crisis – about the government’s debt burden, which now stands at about 70% of GDP. The high interest rates required to finance the perilous fiscal position aggravates it further: higher interest payments account for much of the difference in spending between Brazil and peer countries.

Against this background, Brazil’s National Congress, seeking to regain market confidence, approved an unprecedented constitutional amendment last December that imposes a ceiling on non-interest government expenditures, indexed to the previous year’s inflation rate, for a period of at least ten years. As long as it holds, the spending cap ensures that the size of the government (excluding interest payments) will shrink as a share of national income in every year that the economy experiences real growth. The International Monetary Fund enthusiastically endorsed it at the time, calling it a potential fiscal “game changer.”