SANTIAGO – Europe’s recent experience suggests that a fiscal contraction cannot be expansionary. When tried in Greece, government spending fell, taxes rose, and output collapsed. The same thing happened, in less dramatic form, elsewhere on the continent. Europe’s austerians, as the Nobel laureate economist Paul Krugman likes to call them, lost the argument.
But the lessons of the West need not apply to the rest.
In two South American countries, the idea that fiscal consolidation can spur growth should be revisited. In Brazil, the government has been cutting an enormous fiscal deficit just as the economy is recovering from its deepest recession in decades (though the corruption scandal now embroiling President Michel Temer may derail that effort). In Argentina, President Mauricio Macri’s administration could cut the deficit more aggressively than it has so far, without risking a return to stagnation.
Fiscal contraction can be expansionary if markets expect that tightening today will prevent larger and more disruptive budget cuts (or, worse, a full-fledged fiscal crisis) in the future. In other words, the public debt must be so large, or growing so fast, that the government could soon lose the ability to borrow further. That was true for Greece, but not for most other European countries. Even in the depths of the euro crisis, they could still borrow abundantly at what remained, by historical standards, low interest rates.
Yet another condition is also crucial for fiscal tightening not to wreak havoc on output: the central bank must have room to cut interest rates and allow the currency to adjust. Clearly, this was not the case with the European Central Bank, which kept running up against the now infamous zero lower bound on nominal interest rates. And, by definition, eurozone members like Greece, Spain, and Portugal had no currency of their own to devalue in order to spur exports. Little wonder, then, that fiscal austerity triggered a deep recession and a surge in unemployment.
But things look different across the South Atlantic. Brazilian gross public debt is headed toward 80% of GDP, and real (inflation-adjusted) interest rates are among the world’s highest. Given the fiscal trends that prevailed until recently, an eventual debt crisis was a distinct possibility.
That risk remains, especially if Temer’s problems prevent an indispensable pension reform from making its way through Congress (Brazil spends as much on pensions, as a share of GDP, as Italy does, even though its population is considerably younger). But, despite the political turmoil, markets have been sufficiently calm for the Central Bank of Brazil to cut interest rates repeatedly.
In a heavily indebted country like Brazil, fiscal consolidation can have an unconventional effect on the exchange rate: to the extent that a smaller deficit assuages fears that the government will try to inflate away its debt burden, the currency strengthens. Brazil’s economy is large and relatively closed, so a competitive real exchange rate is less crucial for growth than it would be in a small, open economy. Indeed, because Brazilian corporates have borrowed extensively in dollars (a consequence of sky-high local interest rates), it could well be that an appreciating currency is expansionary in the short-run: companies can clean up their balance sheets without having to shed workers or curtail investment.
An appreciating currency is what the fiscal reform effort was delivering until Temer was recorded endorsing the payment of hush money to a jailed politician. Then both S&P and Moody’s changed their outlook from stable to negative. The currency, unsurprisingly, has weakened from a peak of 3.1 reais to the dollar in mid-April.
In Argentina, the economic achievements of Macri’s team, which inherited a colossal mess from the Peronist Kirchner dynasty that preceded his administration, have been heroic. Nonetheless, the current macroeconomic policy mix could be improved.
Given that concerns about reigniting growth seemed paramount, and that Argentina’s gross public debt, at some 50% of GDP (27% in net terms), is not particularly large, Macri cut taxes and allowed the primary deficit to rise from 4% of GDP in Cristina Fernández de Kirchner’s last year as president to 4.3% in 2016. The official target for 2017 is 4.2%.
The government has been borrowing abroad to cover the shortfall (the overall fiscal deficit was nearly 6% of GDP in 2016). Because Macri reached a settlement with Argentina’s holdout creditors from the sovereign default in 2001, the private sector also has been able to resume foreign borrowing.
The resulting capital inflows have strengthened the currency. Inflation has fallen, but it remains high, despite a strong peso. So the central bank hiked its short-term interest rate in April.
A tighter fiscal policy would enhance the credibility of the anti-inflation program. Falling inflation would make room for a more expansionary monetary policy, allowing the currency to depreciate in real terms and stimulating exports and growth.
Sustained growth in Argentina can come only from the expansion of tradables. Greater certainty that the real exchange rate will be competitive can help unlock investment in agribusiness (Argentina has some of the world’s most competitive natural conditions), energy, and import-competing manufactures.
Delivering that certainty will not be easy, because much of the primary deficit reflects remaining energy subsidies to households and firms; increasing these so-called administered prices (of electricity and natural gas, among others) causes a one-off jump in the relevant price indices, and a temporary spike in inflation. The name of the game, then, is to persuade consumers that the rise in inflation will be temporary, and for that a credible and strong fiscal anchor is key.
So fiscal consolidation in Brazil would strengthen the currency, while in Argentina it would create room for a more competitive real exchange rate. Both effects are good for growth – and that is only in the short run.
Despite the International Monetary Fund’s mea culpa for underestimating the short-run adverse effects of fiscal austerity on European growth, over the longer term, Fund studies make clear, “reducing government debt is likely to raise output, as real interest rates decline and the lighter burden of interest payments permits cuts to distortionary taxes.” One does not have to stick to the controversial 90%-of-GDP threshold identified by Carmen Reinhart and Kenneth Rogoff to believe that a stronger fiscal position can help long-term growth – especially in perennially low-savings, high-interest economies like Brazil.
Argentina and Brazil are not Spain and Portugal. If fiscal adjustment can create opportunities for growth, they should seize it.