By PAULO NOGUEIRA BATISTA JR.*
The issue is complex and controversial, but there is no reason for the market and media's catastrophist speeches
The Minister of Finance recently announced the review of the primary result target for 2025. Previously, the fiscal framework established a surplus of 0,5%, with a tolerance margin of 0,25% of GDP more or less. Now, the midpoint of the band has been reduced to zero deficit, repeating the 2024 target and maintaining the tolerance margin. It was also decided to soften the targets for subsequent years.
As expected, the market and traditional media reacted badly. They gave triumphant kicks like a run over dog, as Nelson Rodrigues would say. They claim that fiscal risk has increased, with negative consequences for the economy. Are there grounds for concern?
I anticipate the article's conclusions: the issue is complex and controversial, but there doesn't seem to be any reason to lose sleep, much less for catastrophist speeches. The most that can be said, in my opinion, is that some projections and expectations will, indeed, have to be revised, but not in a way that justifies alarm. The layman must be aware that the problems raised by market economists, in fact by any economist, are not based on technically grounded certainties, but on more or less plausible conjectures. Informed guesses. In English, it's chic. In Portuguese, less fancy, but more realistic: informed kicks.
This time, due to the complexity of the topic, the column will be a little more technical than usual. I will, in any case, make an effort to make it accessible, at least for the most part, to non-economists. A suggestion that I myself follow when reading more technical texts from other areas: do not be discouraged, reader, if you come across a passage that seems difficult to understand. Skip it and move on. If there are not many passages not understood, the essence of the text can be captured.
Economic issues are too important to be left in our hands alone. And I always remember the warning of the great Keynesian economist, Joan Robinson, who said that one of the main reasons for studying economics was not to be fooled by economists.
External imbalance and inflation?
But let's get to the point. What are the possible macroeconomic reasons to be concerned about the decision to review the targets for 2025 and beyond? I will try to review the main arguments. I start with the ones that seem weakest.
A loosening of fiscal policy, whether through an increase in non-financial spending or a reduction in the tax burden, generates other things being equal expansion of demand. In other words: all else being equal, higher spending and/or fewer taxes translate into higher aggregate demand. Government spending is directly one of the components of demand; Lower taxes increase the private sector's disposable income, which tends to encourage consumption and investment spending. Assuming that there is idle productive capacity (some unemployment of production facilities and the workforce), the increase in demand generates growth in production.
What is wrong with it? In principle, nothing. The Brazilian economy has been growing little, just 3% per year, perhaps less this year, and a fiscal boost would be welcome. What is traditionally claimed as a counter-argument is that this impulse would cause an imbalance in external accounts and/or inflation.
Why? Greater economic growth can generate an increase in demand for imports and can also divert exports to the domestic market. This would reduce the trade balance surplus and increase the current account balance of payments deficit. With regard to inflation, the increase in demand and the heating of the market would stimulate greater increases in prices and wages, obstructing the convergence of inflation to the targets established by the National Monetary Council.
Neither effect seems to be a cause for fuss. The external position of the Brazilian economy is extraordinarily strong. The trade surplus breaks records and the imbalance in current transactions is small. The country's international reserves are high, providing security to the economy on the external side. It can be said with some certainty that the balance of payments and the level of reserves will not be shaken by the revision of the primary result target from 0,5% of GDP to zero in 2025 nor by the discreet revision of the subsequent annual targets. The review will not even tickle the external sector of the economy.
As for inflation, the concern is less misplaced, but it is also not convincing, in my opinion. The increase in demand, it is argued, by increasing the level of utilization of installed capacity and reducing the unemployment rate, would generate excessive market heating, resulting in additional inflation. Before Minister Haddad's announcement, inflation expectations were already slightly “unanchored”, that is, they slightly exceeded the center of the official target, set at 3%. Could an intensification of growth lead to expected inflation moving further away from the inflation target that the Central Bank pursues?
The answer to this question is not clear and crystal clear. Market economists and the Central Bank itself often claim that the “output gap” has narrowed greatly and that any additional narrowing would be dangerous for controlling inflation. What is the output gap? It is an aggregate measure of idleness in the economy, a variable not directly observed, inferred from estimates of potential output. The latter is the level of GDP that could be produced with full use of production factors. If the observed GDP is lower than the potential, the output gap is said to be negative (and positive if the observed output exceeds the potential). It turns out that estimates of potential output are always inaccurate. Therefore, the gap always carries some uncertainty and the dispersion of estimates tends to be high.
To resolve this type of doubt, one possibility is to leave aside the output gap estimates and directly observe existing information on the use of production factors. For example: what is the degree of capacity utilization in the industry? What is the unemployment rate in the economy. Do these directly observable variables suggest that the output gap is really close to zero?
Prima facie, the available data do not confirm the thesis that idleness is small. According to the National Confederation of Industry, the degree of utilization of installed capacity is reasonably stabilized below 80%. And, according to IBGE, the open unemployment rate (unemployed people who looked for work in the survey's reference week) is falling, but is still considerable, at 7,4% at the end of 2023.
Furthermore, broader unemployment measures, also monitored by IBGE, indicate that: (a) many workers are underutilized, that is, working fewer hours than they would like, and (b) there is also a substantial stock of unemployed people who would return to the market if the demand for work recovered or who, by convention, are not included as unemployed in open unemployment statistics because they did not effectively search for work in the reference week. These last two groups are designated by IBGE as “potential labor force”. Considering all these forms of unemployment, the global labor underutilization rate reached no less than 17,3% at the end of last year.
Therefore, it seems difficult to argue that the Brazilian economy is close to fully utilizing its capacity. The risk that the softer fiscal policy could overheat the economy and put pressure on inflation is not significant – especially since the review of the targets was very cautious.
Rising long-term interest rates?
But there are at least two other interconnected lines of argument, which would justify concern about the loosening of fiscal policy. One of them, inconsistent with the previous argument, is that the worsening of the expected primary result would result in an increase in long-term interest rates. This increase would, in turn, cause a decrease in economic growth.
Note, reader, that the argument now points to an opposite risk – that fiscal easing could reduce growth. The expectation of a less robust primary result would lead to an increase in distrust in the market, which would charge higher interest rates to lend to the government over slightly longer terms. Now, the argument goes, it is long interest rates that determine investment and consumption of durable goods. These components of private demand, which depend on credit, would suffer a negative impact from higher interest rates.
The growth of the economy would be harmed, as would its quality, if the impact on investment is significant. An investment rate that is already low would fall even further, compromising the possibility of sustaining the economy's development in the medium and long term. This effect could be exacerbated by the Central Bank, if it reacts to fiscal easing with an increase in short-term interest rates or with any sign of intensifying monetary restrictions in the coming months.
Depending on the size of the effects involved, this reasoning has a paradoxical aspect: fiscal expansion (via a decrease in the primary result former before) can be contractionary and, in the same way, fiscal contraction can be expansionary. Contractionary expansion would occur whenever the recessive impact via interest rates (and, let's say and passant, via exchange rate appreciation) would overcome the expansionary impact via aggregate domestic demand.
Every paradox is intellectually thought-provoking. Thought-provoking, but not necessarily true. This is the case. The recessive effect is based on conjectures that are difficult to support quantitatively. What is the impact of changing targets on market risk perceptions and demand for longer bonds? And if there is a significant increase in long interest rates, what will be the effect on investment and consumption of durable goods? There is no way to measure these effects safely and unequivocally. Conjectures are almost always inescapable in economics, an inexact science par excellence. The hypotheses in question, however, depend on especially fragile conjectures.
The expansive impact, especially from an increase in government spending, is more direct and is felt more quickly. The greater public expenditure, allowed by the more moderate targets, is reflected in an expansion of demand and generates an increase in production – as long as there is some idle installed capacity and unemployed or underemployed workers, as is the case in Brazil now. Therefore, it is unlikely that the recessive effect of interest rates will prevail over the expansionary impact of spending. This last one is clear and direct; the first is uncertain and subject to conjecture. The paradox dissolves in practice. Fiscal expansion tends to be expansionary. And fiscal contraction, contractionary.
It should be noted, in passing, that the expansion of the economy induced, via aggregate demand, by the milder fiscal policy has positive effects that are not always taken into due account. First, by causing an increase in capacity utilization, it stimulates private sector investment (few invest on a large scale while idle capacity remains). Second, increasing the tax base increases revenue automatically, without increasing the tax burden. Third, higher growth improves the primary result also on the public expenditure side. This is because the increase in jobs resulting from the expansion of the economy reduces cyclical expenses such as aid to the unemployed.
The unsustainable lightness of public debt
I return to the thread. The other argument that is also very popular among market economists and in the traditional media is that lower ambition in terms of primary results carries the risk of an uncontrollable or unsustainable increase in public sector debt.
This argument is largely based on accounting identities. The growth of debt (including monetary liabilities) corresponds to the deficit. This is equivalent to the sum of the primary result (revenue minus non-financial expenses) and net interest expenses (expenses minus financial income). Interest expense, in turn, results from the average interest rate multiplied by the debt stock. The trajectory of the public debt/GDP ratio, the variable that summarizes all this, therefore reflects three main variables: the primary surplus as a percentage of GDP, the interest rate and the GDP growth rate.
Combining these identities, we arrive at the following, well-known result: the debt/GDP ratio is an inverse function of the economic growth rate and a direct function of the interest rate and the primary deficit. If the interest rate exceeds the GDP expansion rate, the debt only stabilizes in relation to GDP when there is a primary surplus. The greater the difference between the interest rate and the economic growth rate, the greater the surplus required to stabilize the debt.
When the government abandons the objective of generating a primary surplus in 2025, the market redoes its calculations and comes to the obvious conclusion that, other things being equal, the debt/GDP ratio will be higher at the end of 2025 than previously estimated. Ceteris non paribus, although. If the softening of fiscal policy actually increases the risk premium and the interest rate paid by the government, as the market usually assumes, debt growth will be even greater.
Can we conclude, then, that the change in fiscal policy poses a risk of uncontrolled debt expansion? I don't believe it and I explain why. There are several flaws and omissions in the argument that I have tried to summarize in the previous paragraphs. The first is that a quantification of the effect of changing the target from a surplus of 0,5% of GDP to zero in 2025 and relaxing the targets in subsequent years will hardly produce significant differences in the debt stock. There was no radical revision, just modest adjustments. And the possible negative reinforcement arising from the rise in average interest rates is conditioned by the uncertainties mentioned when we discussed the false paradox of contractionary fiscal expansion.
It should also be noted that market economists focus unduly on gross debt. The public sector's net debt, the most relevant variable, from which the government's net assets are deducted (the main one being the country's international reserve), is much lower than the gross one. Net debt is around 65% of GDP; gross around 74%. What's more: public debt in Brazil is internal, issued domestically in national currency. The participation of non-resident investors in domestic debt is small, around 10%. And the Brazilian public sector, thanks to the high international reserve, has a negative net external debt. In short, due to its composition and structure, the debt is manageable without major scares. It is true that the average term is short, but debt refinancing occurs without major difficulties.
One should not lose sight, on the other hand, that slightly more modest and more realistic objectives increase the government's flexibility. There is room to continue with the policy of gradually increasing the minimum wage in real terms, to strengthen social transfers or to recover public investment, which remains depressed. Even the new targets, which are only slightly less ambitious, will be difficult to achieve, requiring considerable discipline and likely obstructing public policies that the government considers priorities.
The more moderate goals also open up, I know, additional space for parliamentary amendments, which generally worsen the quality of public spending. But anyway, it's here life, are the hardships of a situation in which Congress has become more powerful and decides based on very narrow, typically parochial criteria, especially in a year of municipal elections.
In any case, the fact remains that, except in exceptional circumstances that are not on the horizon, Brazilian public debt can be rolled over with relative ease. The moderation of fiscal objectives does not change this situation. Once the initial nervousness has passed (the market apparently expected a smaller reduction in targets), the dust will settle.
The primary result projections will, indeed, be revised slightly upwards, with the argument that the softening of targets indicates less of the government's commitment to “fiscal responsibility”. By how much will the median projections for the coming years increase? We'll soon know. But believe me, reader, they will be new informed guesses. It's not worth being too impressed by the kicks, noises and grunts of the market and the media.
The Ministry of Finance cannot, of course, ignore media and market reactions. It is normal that the minister and his team are monitoring the effects of the new goals with some anxiety. In part, the problem is self-inflicted. It would not exist, at least not to the same extent, if the fiscal framework established in 2023 had been more flexible and realistic, as several heterodox or less orthodox economists suggested at the time, including the one who writes to you. (Sorry, reader: I couldn't resist a little I told you so!)
Homage from vice to virtue
Finally, a comment on the hypocrisies of the market and the media. We know that, as La Rochefoucauld said, hypocrisy is vice's homage to virtue. But let's not exaggerate, please.
Is the concern really about “fiscal risk”? I doubt it is. This risk depends, as we have seen, on the size of the deficit and the trajectory of public debt. It turns out that the relevant deficit to measure the increase in debt is not the primary one, but the total deficit, which also includes interest on the debt. And, as previously indicated, the total deficit is, by definition, the sum of the primary deficit and interest.
Now, what do these identities show? Among other things, even when there is a primary surplus or small deficit, the debt can grow quickly if the financial expense is heavy. This is exactly what we see in Brazil as a result of the high interest rate charged by the Central Bank. Monetary responsibility leads to fiscal irresponsibility – a paradox that is valid. For 2024, market forecasts, collected by the Central Bank (before reviewing the targets), place net interest expenditure at around 6,1% of GDP; the primary deficit, at something like 0,7% of GDP only. In other words, interest expenses weigh almost nine times more than the primary deficit!
The main “fiscal risk” factor is the interest rate. Insincere question: why does the market and the media never complain about it?[1]
*Paulo Nogueira Batista Jr. is an economist. He was vice-president of the New Development Bank, established by the BRICS. Author, among other books, of Brazil doesn't fit in anyone's backyard (LeYa). [https://amzn.to/44KpUfp]
Extended version of article published in the journal Capital letter, on April 19, 2024.
Note
[1] Thanks to the review by Lavínia Lima and Flávia Vinhaes, several errors, repetitions and omissions were avoided. However, I am solely responsible for remaining problems and the conclusions of the article.
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