Heterodox, but not much

Image: João Nitsche


Observations on the fiscal policy of a future Lula government

Today, I will write primarily for economists, but I hope that the text will be accessible, at least in part, to others as well. I want to address a controversy among heterodox economists. There are basically two groups. On one side of the controversy, the more traditional ones, for whom deficits and public debt are relevant concerns. On the other hand, the most innovative and extremists, for whom this is essentially nothing more than an orthodox myth, derived from a misunderstanding of economics. The first group is made up of conventional Keynesians. The second is influenced by Modern Monetary Theory, which emerged a few years ago in the US and had great repercussions there and in other countries. The controversy is complex; I will only address some of its aspects.


A Preliminary Warning

Before getting into the subject, a brief caveat. It is a matter, reader, of a quarrel within the same family. I am well aware that these fights tend to be the worst, and can become really fratricidal. For this very reason, tempers should be tempered. All the more so as economics is far, far from being an exact science. I don't even know if there is any "exact" science. Be that as it may, the truth is that economics excels in inaccuracy. We economists are not, strictly speaking, sure of anything. Von Mises went on to say, tongue in cheek, that the only unquestionable thing in economics would be accounting identities.

Furthermore, we cannot forget that the national political framework is very delicate. It is not possible to feed internal struggles in the progressive field capable of diverting us from the essential, which is to fight Bolsonarism and the so-called neoliberal economic ideals, but in reality paleoliberal, associated with it.

There is a factor in the Brazilian situation that exacerbates the theoretical controversy among heterodox: the approach of a possible election of Lula. And the central question becomes: what should be the economic policy and, in particular, the fiscal policy, spending and taxation, of this possible future government?

What I will say next is controversial. I offer these reflections as a modest contribution to an intricate debate, which will continue for some time.


The extreme heterodoxy

I will dedicate myself to the most interesting group - the extreme heterodox. What they say, with a few qualifications, is that there is no effective cap on public spending when the state issues a sovereign currency and has no significant debt denominated in foreign currency. In this case, all (or almost all) debts accrued by the public sector are paid in a currency that the state issues and controls. Therefore, the idea that debt can become unpayable or unsustainable is essentially an orthodox legend. There is no need to worry about the financing of public spending, but primarily about the nature of the spending. The argument is not valid, it is highlighted, for dollarized economies or with a government heavily indebted in foreign currency.

Perhaps the previous paragraph, a tight summary, as the lawyers say, does not do the argument justice. I ask you to correct me, if necessary, and I will continue.

With the exception that I may be making a caricature, I would say that the extreme argument, although instigating, does not seem entirely correct. Mind you, reader, not because it is extreme. Brazilians have (or had) a habit of presenting themselves as moderate, balanced, etc. and is, as a general rule, prejudiced against extremism. But that's silly. If the truth is in the extreme, let's go for it! The problem is that, in this case, it isn't.

Modern Monetary Theory has made an important contribution to debunking, in the US and later elsewhere, the simplifications of economic orthodoxy, which can be as powerful as it is ignorant. Decades have passed, but I must say that I still temperamentally identify with the iconoclasts. And I go further: I frankly find the race among some progressive economists to show themselves to be “responsible” and “serious”, endorsing, in whole or in part, the shallowest economic prejudices of the market and the buffoon crowd.


Relevance of public sector deficits and debt

Even so, reader, I don't see how to fully justify the extreme heterodoxy. It would be wonderful if there were no fiscal restrictions and if it were enough to get rid of an outdated and pernicious set of ideas. Unfortunately, it's not quite like that. Deficits and public sector debt are not irrelevant, or of little relevance, even in economies with their own currency and governments not indebted in foreign currency.

Let's see why. The least controversial reason, already present in Abba Lerner, one of the main theoretical ancestors of Modern Monetary Theory, is the restriction of productive capacity. An expansion of the fiscal deficit, which reflects a policy of increasing spending or reducing the tax burden, may run into limitations of aggregate supply when the pre-existing degree of utilization of existing capacity is high. And, note – the capacity constraint may be relevant even if the average idleness level is high. A dispersion around this average can cause bottlenecks and sectoral demand pressures on prices and wages to appear well before the economy approaches full employment of labor, production facilities and other production factors.

A counter-argument can be asked: but is this valid even if the expansion of government spending or the decrease in tax revenue results in an increase in the economy's productive capacity, via greater public investment or incentives to private investment? Even so. Supply responds more slowly than aggregate demand. Once the pre-existing capacity is exhausted, or when this limit approaches, a scenario of excess demand sets in, with consequences in terms of higher inflation and imbalances in the balance of payments in current transactions.

The balance of payments imbalance leads us to a second reason for not accepting extreme heterodoxy. When the State is not an issuer of internationally liquid currency, the economy is potentially subject to an external restriction. The central aspect here is not even the current account of the balance of payments, but the movement of capital. If the expansive fiscal policy causes capital holders to perceive that the public debt is growing unsustainably, there tends to be pressure on the exchange rate and/or international reserves, with adverse impacts on inflation, interest rates and on other aspects of the economy.

Note that, in the absence of effective capital controls, the relevant reactions extend to domestic capital holders as well. It should also be noted that the absence of public debt in foreign currency does not eliminate the problem. It suffices that the country's net external liabilities or net domestic assets are high, as is usually the case, in relation to the stock of international reserves at the Central Bank.

But the question still remains, on which the extreme heterodox insist: does it make sense to talk about debt “sustainability”? Or is this just an orthodox prejudice, to be overcome by abandoning outdated ideas? Was there, therefore, a question of principle in the previous paragraph? Two answers here. One, weaker, is that the holders of capital believe in these “outdated ideas” and may react accordingly. This answer is weaker because it is possible to admit that, over time, the shock with reality would dissipate prejudices.

More fundamental is recognizing that, yes, the public debt can prove to be “unsustainable”, although not with the speed and predictability imagined by orthodoxy. This is because debt can snowball and reach a prohibitive proportion of GDP and national wealth.

As? Debt growth corresponds to the deficit (discounting the increase in the monetary base). The deficit, in turn, depends on interest expenditure, which reflects the pre-existing debt stock and the average interest rate on the debt. Debt generates a deficit that generates debt in ever-increasing amounts – unless the public sector is able to offset this tendency with high primary surpluses. What matters, however, is not the absolute value of the debt, but its relationship with GDP, tax revenue and the stock of national wealth. For convenience, it is customary to compare debt to GDP, which appears as proxy of the public sector's wealth and ability to pay.

With a bit of arithmetic, it can be shown that the key variables in determining the trajectory of the debt/GDP ratio over time are, on the one hand, the differential between the interest rate on debt and the growth rate of the GDP and, on the other hand, the primary result. The variation in the debt/GDP quotient is a direct function of this differential and an inverse function of the primary result.

The argument of the extreme heterodox is that it is enough to ensure an interest rate lower than the economic growth rate to stabilize the debt/GDP ratio without the primary surplus needed to achieve such an objective being too high. Moreover, they point out, the economic growth induced by the expansive fiscal policy and the modest interest rate policy not only increases the denominator of the ratio, but also facilitates the generation of surpluses in the primary accounts by raising revenues and decreasing cyclical expenses (insurance, unemployment and others).

All of this is true, but only up to a point. The aforementioned capacity and balance-of-payments constraints may make the combination of expansionist fiscal and monetary policies unfeasible. But if the interest rate then exceeds the economic growth rate, it becomes difficult to stop the increase in the debt/GDP ratio. This increase cannot continue indefinitely, as it cannot exceed the stock of national wealth. Long before hitting this ceiling, debt growth will lead to an increase in risk premiums embedded in the interest rate on government bonds, feeding back debt growth via the financial component of spending.

The government will end up confronted, sooner or later, with the always politically difficult task of cutting spending or raising taxes – difficult in itself and harmful, moreover, for aggregate demand and GDP, which throws the economy into a vicious circle and feeds back , also in this way, the growth of the debt.


Heterodoxy, but no mucho

Extreme heterodoxy has many merits, including some I haven't gotten around to here. It is superior, even in the perhaps caricatured version that I have criticized here, to the crude fiscalism of many orthodox economists. But by favoring the perception that there are no, or few, limits to public spending, it can contribute to economic policy disasters.

As President Ernesto Geisel used to say, a government will be composed, for all eternity, of a ministry in which all ministers want to spend – all but one, who is responsible for saving: the Minister of Finance or Economy. If the latter wants to be a spender too, then the government is at risk.

*Paulo Nogueira Batista Jr. he holds the Celso Furtado Chair at the College of High Studies at UFRJ. He was vice-president of the New Development Bank, established by the BRICS in Shanghai. Author, among other books, of Brazil doesn't fit in anyone's backyard (LeYa).

Extended version of article published in the journal capital letter, in 1st. April 2022.


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