A Brazilian budget cautionary tale for the United States
Brazil’s unfolding foreign exchange and budget crisis might offer a useful cautionary tale to United States economic policymakers. It might alert them to the economic risks associated with an unhealthy combination of highly compromised public finances and an uncomfortably high level of inflation. It might also throw cold water on the current Modern Monetary Theory fashion, which holds that high budget deficits do not matter.
As in the U.S., Brazil’s massive budget policy response to its COVID-19-induced recession inflicted major damage to the country’s public finances. Last year, as a result of a 17 percent of GDP increase in public spending, Brazil’s budget deficit blew up to a record 10 percent of GDP. That in turn caused the country’s public debt to rise to a record of almost 100 percent of GDP. That ratio far exceeded the 60 to 70 percent of GDP debt level that is generally considered the level that emerging market economies should not exceed to avoid a public debt crisis.
Similar to the U.S., albeit to a much greater degree, Brazil is now experiencing serious inflationary pressures. Whereas the Bank of Brazil has a 3.5 percent inflation target, headline consumer price inflation is now running at above 10 percent. It is doing so partly as a result of higher food and energy prices that could prove to be transitory. However, more importantly, it is doing so because of expansionary monetary and fiscal policy boosting aggregate demand to a level that is now running into supply bottlenecks.
Also hardly helping the inflation outlook has been the appreciable weakening of the currency. Since the start of the year, the Brazilian real has lost around 8 percent of its value to the U.S. dollar, making it one of the world’s worst-performing currencies this year.
Among the factors driving the currency lower has been the fear that the government will increase public spending ahead of next year’s presidential election regardless of the likely inflationary consequences of such spending. As if to validate such fears, the government of President Jair Bolsonaro recently announced an increase in government transfer payments that are not covered by the federal spending cap.
It’s concerning that Brazil’s currency has declined so much in today’s world of ample global liquidity. This is particularly the case considering that Federal Reserve Chairman Jerome Powell has indicated that it is the Fed’s intention to start tapering its bond-buying program before the end of the year and to curtail this program by mid-2022. Past experience with Fed tapering would suggest that Brazil could experience additional currency pressure as capital is repatriated from Brazil to the U.S.
All of this raises an impossible policy dilemma for the Central Bank of Brazil. If it does not substantially hike interest rates to a level that is positive in inflation-adjusted terms, it risks losing control of inflation and inviting a currency crisis. But if it does substantially raise interest rates, it risks precipitating an economic recession and exacerbating the country’s public finance problem. This is particularly the case considering the very short-term nature of Brazil’s public debt, which boosts the government’s gross borrowing needs to more than 20 percent of GDP each year and causes central bank interest rate hikes to quickly feed through to higher government interest payments.
The moral of the Brazilian story for the U.S. is that, if the Federal Reserve is to be spared the Bank of Brazil’s acute policy dilemma, U.S. policymakers should make every effort to quickly step off the Brazilian budget deficit and inflation path.
To do so, the Fed should become less sanguine than it seems to be today about the recent rise in U.S. inflation to a 30-year high. At the same time, the Biden administration should wean itself from the dangerous Modern Monetary Theory dogma according to which high budget deficits do not matter.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.