Latin America and the Caribbean faces a punishing economic landscape. Fiscal deficits and debt levels have risen as a consequence of the COVID-19 pandemic and the Russian invasion of Ukraine, and with monetary policy tightening in the United States and Europe, the era of cheap and easy financing is over.
In this ever more thorny environment, the region needs to urgently consolidate, or reduce, its fiscal deficits. It desperately needs to restore fiscal discipline. Failing to do so could be catastrophic for its people, especially the poor and vulnerable who suffer the most from rising inflation and economic crises. It would also deter productive foreign and domestic investments, further curtailing the region’s already low, long-term growth rates.
The Dangers of Boosting Debt and Printing Money
If countries of the region fail to reduce their fiscal deficits, they will have to finance them and there are only two ways to do so: increasing debt and printing money. Printing money to finance deficits, of course, is extremely risky, not least because it can lead to growing inflation and unhinged inflation expectations, which are then costly to reverse. Increasing debt is as well. Debt levels are already historically high. The average public debt to GDP ratio increased from 58% in 2019 to 72% in 2022, well above the average of the preceding decades. With global interest rates rising, the cost of financing debt will only rise too. All these factors potentially lead to an unsustainable situation.
The region has trod this path before, including during much of the 20th century. Demands for more government spending combined with tax evasion and other troubles in raising revenue, often led to fiscal deficits. These were financed through debt, when financing from abroad was possible; through financial repression, where government’s kept domestic interest rates artificially low; or through monetary financing when external or domestic funding could no longer be found. The depressing results of this fiscal indiscipline were inflationary and even hyper-inflationary episodes and economic and financial crises, with the worst outcomes materializing during the so-called “Lost Decade” of the 1980’s, a period of recurrent and costly debt crises.
Structural Problems and Fiscal Deficits
Many structural problems played into this dynamic. As described in a very interesting new book edited by Timothy Kehoe and Juan Pablo Nicolini, volatility in terms of trade, external financial shocks, debts denominated in foreign currencies and subject to valuation effects via currency fluctuations, contingent liabilities –like the need to cancel previously unpaid debts or recapitalize banks with public funds— and other factors, combined with institutional weakness, made it extremely difficult for governments to eliminate fiscal deficits.
Kehoe and Nicolini’s book present 11 case studies comprising a detailed monetary and fiscal history of Latin America for the period 1960-2017. These case studies provide compelling evidence that the chronic excess of outlays over revenues –i.e., persistent fiscal deficits— were an inescapable trap for the region for decades. They show that the political economy of fiscal reforms is difficult, and that political incentives always push in the direction of delaying consolidation, with governments trying to buy time until crises force their hand.
But that doesn’t have to be inevitable. By 2019, 7 of the 11 countries that were studied in their book had imposed reforms and managed to improve fiscal policy outcomes for more than a decade. Some of these reforms involved the imposition of fiscal rules that allowed countries to save in good times to be able to spend in difficult ones. Others have had different formulas, involving varied changes to tax and spending policies.
Curbing Fiscal Deficits While Preserving Public Investment
Now is the time to build on those strengths. It is the time to pursue fiscal consolidation policies that help preserve the gains of the hard-fought battles for fiscal discipline. Essential, as mentioned in a previous blog, however, is that deficit reduction be done in such as way as to preserve productive public investment to the extent possible to increase the productivity of capital and labor and create incentives for private investment. This can prevent a reduction in long-term output and the worsening of the region’s already sky-high inequality.
Credible fiscal institutions that guaranteed efficiency, equity, and sustainability would be a critical asset for the region. Reforms to restore fiscal discipline should rank high in policymaker’s priorities. Changes made today may have lasting benefits, but those benefits start to accrue today. The region cannot afford to repeat the mistakes of the past.