Halfway through his third (nonconsecutive) term, Brazilian President Luiz Inácio Lula da Silva is dealing with significant economic trouble. Although markets have recovered somewhat in recent weeks, at the peak of the market turmoil, in early January, the real had lost nearly 15% of its value against the dollar compared to early October, while Brazil’s main stock index, the Ibovespa, lost 10 percent of its value over the same period. The trigger for the most recent meltdown, in mid-December, was the announcement of a fiscal adjustment package that fell short of expectations.
While Latin America is often associated with economic upheaval, the situation in Brazil is not a typical emerging-market crisis. Brazil’s sovereign debt is overwhelmingly in local currency, and although its current account deficit has widened recently, it has plenty of foreign reserves. It is thus not particularly vulnerable to running out of dollars, and exchange range fluctuations do not have an immediate impact on its debt burden.
Halfway through his third (nonconsecutive) term, Brazilian President Luiz Inácio Lula da Silva is dealing with significant economic trouble. Although markets have recovered somewhat in recent weeks, at the peak of the market turmoil, in early January, the real had lost nearly 15% of its value against the dollar compared to early October, while Brazil’s main stock index, the Ibovespa, lost 10 percent of its value over the same period. The trigger for the most recent meltdown, in mid-December, was the announcement of a fiscal adjustment package that fell short of expectations.
While Latin America is often associated with economic upheaval, the situation in Brazil is not a typical emerging-market crisis. Brazil’s sovereign debt is overwhelmingly in local currency, and although its current account deficit has widened recently, it has plenty of foreign reserves. It is thus not particularly vulnerable to running out of dollars, and exchange range fluctuations do not have an immediate impact on its debt burden.
Instead, what we are seeing are the fruits of careless fiscal policy—fruits that foreshadow what a slow-burning fiscal crisis might look like in an advanced economy such as the United States.
Brazil’s ratio of public debt to its GDP has been trending up over the years—from a little more than 50 percent a decade ago to close to 80 percent now—due largely to increases during the administrations of Dilma Rousseff and Michel Temer in the late 2010s. Low productivity growth means that GDP per capita grows very little; at the same time, the Brazilian state’s role in the economy is very large compared to other middle-income countries. According to data from the IMF, Brazilian government spending as a share of GDP—including interest expenditure—was more than 45 percent in 2022, compared to closer to 35 percent in Argentina and Colombia and about 29 percent and 23 percent in Mexico and Peru, respectively.
Despite that context, the current Workers’ Party government, led by Lula since his return to office in 2023, has done little to restore fiscal credibility.
Upon reassuming office, Lula introduced a framework that was approved by the National Congress in August 2023 and was meant to place the country on a sustainable fiscal path by turning its primary budget deficit (estimated at 0.4 percent of GDP for 2024) into a 1 percent primary surplus by 2026 and limiting spending thereafter.
As is often the case with politicians pretending to handcuff themselves, the Lula government’s commitment to its own fiscal rules has been weak. In November, the Brazilian Senate’s Independent Fiscal Institution concluded that spending commitments undertaken by the Lula government would cause the spending cap to become unsustainable in the medium term.
Instead, noninterest spending has increased in line with GDP—that is, at a pace faster than inflation—driven in particular by expenditures related to health care, education, and social security. As a result, the primary deficit has not come down sufficiently and continues to exceed levels compatible with debt stabilization.
This is not the first time that Brazil’s political class has failed to accept the constraints imposed by a formalized fiscal framework. In late 2016, the Brazilian Constitution was amended to limit the growth of public expenditures to the rate of inflation during a period of 20 years. While this spending cap was supposed to constrain fiscal policy for at least a decade, it was modified repeatedly under the government of former President Jair Bolsonaro and lost its punch.
To be fair, this situation is not at all unique to Brazil. The European Union Stability and Growth Pact—an ever-evolving set of fiscal rules designed to limit each member states’ deficits to 3 percent and its debt levels to 60 percent of GDP—has never in its quarter century of existence managed to bind policymakers. Despite a plethora of monitoring efforts, preventive procedures, and correction programs, only a handful of the union’s 27 members are below both cutoffs. In the United Kingdom, Chancellor Rachel Reeves has struggled to preserve the credibility of her own fiscal rules from the moment she announced them.
In Brazil, this failure to comply with the fiscal framework has boosted aggregate demand to unsustainable levels. This overheating has manifested itself not only in record-low unemployment—desirable, perhaps—but also in inflation expectations that have started to creep away from target.
In response, the Brazilian central bank has started raising rates again, after lowering them from mid-2023 to mid-2024, and has promised more increases. This is textbook behavior: In an overheated economy, the central bank raises rates to slow down economic activity, which should reduce inflationary pressures in turn.
But instead of lowering inflation expectations, higher interest rates have been part of a vicious cycle that has also involved a sharp sell-off in the currency and even higher expected inflation.
The fundamental problem is that Brazil’s fiscal anchors have come unmoored. An increase in interest rates causes the cost of servicing the debt—now at more than 7 percent of GDP—to rise, which makes fiscal policy even more unsustainable. This, in turn, feeds back into higher interest rates through a higher risk premium and higher inflation expectations, which makes fiscal policy even less sustainable—and so on.
No recent Brazilian government has shown the necessary urgency in tackling unsustainable debt levels. The longer that it takes to stabilize the debt level, the more costly the adjustment will become, and the less willing governments will be to pay the necessary—but sometimes painful—short-term costs.
Some market participants are fearful that with presidential elections upcoming in 2026, Lula will be even less willing to embark on a serious program of fiscal consolidation during the second half of his mandate.
There is very little that the central bank or monetary policy can do in this situation, which economists refer to as a shift toward “fiscal dominance.” Instead, the government needs to credibly commit to sounder fiscal policy. Given the size of Brazil’s public sector compared to its peers, that should involve spending cuts as opposed to a mere narrowing of the budget deficit through tax increases.
Unfortunately, the Lula government does not appear to realize that its policies might be self-defeating. Low unemployment can only be sustained as a result of balanced growth that does not result in accelerating inflation. The burden of higher inflation falls mostly on poorer households, while increased interest payments on the national debt go mostly to the wealthy. Brazil’s program of fiscal expansion might have the effect of worsening income inequality in a country that is already considered to be one of the most unequal in the world.
Brazil is important in its own right, but these events should also serve as a warning for the rest of the world. We saw in September 2022, during then-U.K. Prime Minister Liz Truss’s “mini-budget” crisis, that a similar dynamic—of seemingly minor fiscal policy decisions signaling a potential shift in the macro policy regime—is possible in wealthy, developed countries. And in most of the developed world, debt levels have increased sharply in the past two decades, increasing the chances of a fiscal mishap.
In the United States, long-term interest rates have not come down even as the Federal Reserve has been cutting the short-term interest rate. Higher interest rates reflect, at least in part, the effect of much higher debt levels and deficits in the United States. Since 2019, the U.S. debt level has increased by $11 trillion—an increase of roughly 20 percentage points in the debt-to-GDP ratio. Market participants have begun to incorporate the risk that the United States might have to reduce the real value of its debt by allowing higher inflation, similar to what happened in 2021 and 2022.
There are two options for Washington’s policymakers to respond. One is fiscal consolidation. That option seems unlikely to materialize in the short run, given the Trump administration’s agenda of tax cuts and planned increases in defense and immigration enforcement spending. It is also something that Congress hasn’t done for decades.
The second option is for Congress and the president to continue going down the current route. This option implies, at the very least, Washington accepting permanently higher interest rates, as markets anticipate that management of the debt will ultimately happen through bouts of elevated inflation.
Yet the Brazilian example shows that the risk is not merely higher interest rates or permanently higher inflation—and the economic cost associated with them. A loss of confidence in the fiscal sustainability of the United States might also undermine the effectiveness of monetary policy as well as the country’s ability to respond to crises such as the COVID-19 pandemic and the global financial crisis. It would undermine the United States’ habit of recovering stronger and faster from downturns than the rest of the West.
Slower recoveries would further weaken Washington’s ability to sustain whatever remains of the famed rules-based order and confound its already complicated politics.
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