The Path to Fiscal Dominance

BRAZIL ECONOMICS - Report 15 May 2023 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

In an article published in 1981, Sargent and Wallace described the evolution of a non-cooperative game between a fiscal authority and a politically independent monetary authority. If the fiscal authority expands spending, leading to unsustainable growth of the public debt, the monetary authority can resist the effects for a certain period, but the end result will inevitably be higher inflation.

The Lula government has decided to put the hypothesis of Sargent and Wallace to the test. The only assurance given by the new fiscal framework is a growing spending, which will be financed partly by an increased tax burden and partly by enlarging the public debt. The “unpleasant arithmetic” of Marcos Lisboa and Marcos Mendes indicates that even with a large increase of the tax burden, the public debt in the last year of the current Lula administration will have reached around 85% of GDP. With inflation high and expectations unanchored, the Central Bank has repeatedly stated that the interest rate will remain restrictive for an extended period, despite the pressures exerted by the government to lower the rate no matter what.

However, 2024 will be the last year of Campos Neto as president of the Central Bank, after which he will be replaced by someone more obedient to the urgings of Lula for reduction of the interest rate. The upshot is that the country is headed toward fiscal dominance.

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