Learning from Latin America

Security, spending, and fiscal sustainability

Over the last few decades, Latin America has served as our economic laboratory. Countries across the region have experimented with virtually every economic policy imaginable. Government intervention has ranged from direct nationalization of key industries to partial state ownership models and full privatization programs. Trade policies have spanned from high tariff barriers and import substitution to gradual market opening and comprehensive free trade agreements. Monetary approaches have included currency pegs, managed float systems, complete dollarization, and full currency replacement through multiple currency reforms.

Fiscal policies have ranged from monetization leading to hyperinflation, strict fiscal rules with surplus targeting, and countercyclical spending policies. The capital account has seen strict limitations on foreign investment to gradual liberalization and open capital accounts. Social policy has included conditional cash transfer programs, universal basic services, privatized social security, and mixed public-private healthcare systems. These experiments have produced dramatic outcomes, from hyperinflation to deflation and from rapid growth to secular regression.

A Consensus on Economic Principles

But out of the chaos, a surprisingly wide consensus on (macro)economic principles has emerged:

• Trade barriers should be low or fully eliminated

• Central banks should be independent

• Monetary financing of deficits should be avoided

• Governments should aim for low deficits

• Fiscal rules are helpful for these purposes

Indeed, the most striking feature of Latin America's current economic landscape is how widely accepted these principles have become across the political spectrum. Left-wing leaders who campaigned as economic revolutionaries have largely governed as fiscal pragmatists. Gabriel Boric entered office in Chile as a macroeconomic populist (as described by Dornbusch and Edwards), vowing to fight the country's fiscal orthodoxy. Yet once in power, he not only upheld Chile's existing fiscal rule (which prescribes a maximum cyclically-corrected budget deficit) but appointed Mario Marcel — the sitting and very mainstream central bank governor — as finance minister. Chile hasn't had very high inflation since the 1970s and no debt or banking crisis since the early 80s — longer than most advanced economies.

Figure 1. Find the Populists

Debt to GDP ratios, selected EU and Latin American Countries

Source: IMF, General government debt to GDP ratio (except Mexico, general government debt not available in IMF, central government debt in 2023)

In Brazil, Lula took power promising a return to activist government spending, but for a long while retained the central bank chief who had served under Bolsonaro. In Mexico, AMLO kept deficits under control for 5 years (despite his populist platform), did not interfere with Central Bank independence and maintained the previous governor until his term expired. His successor, Claudia Sheinbaum, when confronted with the threat of Trump tariffs, has become a staunch defender of free trade. In Colombia, Gustavo Petro campaigned on radical economic transformation but has mostly maintained fiscal discipline once in office. Ecuador's leftist governments under Rafael Correa and his successors continued dollarization despite ideological objections. Uruguay's left-wing Frente Amplio coalition governed for 15 years while maintaining orthodox monetary policy and fiscal restraint. Even Bolivia under Evo Morales, despite his socialist rhetoric, maintained surprisingly conservative fiscal management during most of the commodity boom years, creating a sovereign wealth fund rather than spending all resource revenues.¹

Even more extraordinary is Peru's case. Despite cycling through six presidents since 2000 (all of them having faced jail terms for corruption charges), the Central Reserve Bank has had the same governor — Julio Velarde — since 2006. Every president has felt bound to reappoint him to show commitment to macroeconomic stability.

Indeed, in the main Latin American countries (always excluding Argentina), Central Banks have survived the populist stress test with their independence intact.

This was also proven by their fast reaction to the recent worldwide inflation spike. Brazil's central bank began raising interest rates in March 2021, a year before the Fed. Mexico’s central bank started the rate hike cycle in June, Chile’s in July, and Perú’s in August 2021. Across all these countries, inflation remains near targets, fiscal deficits stay under control, and we have heard of no ‘heterodox’ macroeconomic policy proposals.

This does not mean these leaders have broadly embraced good economic policies. AMLO increased social expenditures and funded questionable infrastructure, relocating Mexico City's airport and building a huge refinery in his home state. Also, in his last year in office he did run a huge deficit to help with the election effort of his (ultimately victorious) candidate. Boric expanded Chile's welfare state and undertook aggressive minimum wage increases. In Brazil, Lula pushed through controversial labor laws favoring unions and expanded state bank lending to preferred sectors. Lately, his fiscal policies have raised serious concerns. But, while they continue to distort incentives and choke growth, even Latin America’s new populist leaders are nowadays careful not to finance their plans by printing money, having internalized the hard lessons from the sequence of macroeconomic disasters that devastated the region in previous decades. (Argentina, as always, remained the exception, repeatedly relapsing into inflationary chaos, proving that painful lessons don't always translate into changed voter and politician behavior.²)

Lessons Europe Ignored

Contrast this with Europe. As I discuss in my forthcoming (on June 17!) Princeton University Press book with John Cochrane and Klaus Masuch, the European Central Bank is increasingly being drawn into fiscal policy. Beginning with the sovereign debt crisis and continuing through the pandemic, the ECB now regularly intervenes to prevent debt crises by purchasing government bonds—effectively providing fiscal support to member states.³

The ECB's intervention in fiscal policy has deepened significantly since the sovereign debt crisis. From its initial cautious bond purchases under the Securities Market Program during 2010–2012, through the expansive Outright Monetary Transactions following Draghi's "whatever it takes" statement, the ECB has gradually blurred the lines between monetary and fiscal domains. By late 2023, the Eurosystem's holdings of sovereign bonds amounted to nearly €5 trillion — about one-third of eurozone GDP — up from just €0.2 trillion in 2014.

These interventions create bad incentives for governments. Bond markets check the government's behaviour (as we have seen in the UK the last few months). As a recent JP Morgan note put it:

Here’s the interesting thing about the stock market: it cannot be indicted, arrested or deported; it cannot be intimidated, threatened or bullied; it has no gender, ethnicity or religion; it cannot be fired, furloughed or defunded; it cannot be primaried before the next midterm elections; and it cannot be seized, nationalized or invaded. It’s the ultimate voting machine, reflecting prospects for earnings growth, stability, liquidity, inflation, taxation and predictable rule of law.

The same holds for bonds: the market cannot be coerced with the usual tools of state power. But it can (within limits) be bought off by central banks. With market discipline diluted, states like Italy and Spain — whose debts substantially exceed Maastricht criteria — no longer face the same pressures for structural reforms. Of the 12 original euro members, only three — Ireland, Luxembourg, and the Netherlands—remain below the EU's 60% debt reference value. Greece (162%), Italy (137%), France (110%), Spain (108%), and Belgium (105%) carry the largest burdens.

What began as an emergency measure has evolved into a predictable backstop. The 2022 Transmission Protection Instrument formalized the ECB's role in suppressing sovereign spreads, essentially removing market discipline as a constraint on government spending. Moreover, these interventions have reshaped financial markets. Banks, incentivized by regulatory structures to hold sovereign bonds as risk-free assets, became increasingly dependent on ECB interventions.

Unlike in Latin America, where painful lessons of fiscal irresponsibility led to genuine reform, the ECBs behaviour now shields governments from the consequences of unsustainable policies. The long-term result is weakened fiscal discipline, growing debt burdens, and eventually, the risk of inflation as the only remaining escape valve for countries that can neither default within the eurozone nor grow their way out of mounting obligations.

This is not academic. Italy's SuperBonus program, which we explained here, illustrates this exact dynamic. Budgeted at €35 billion, the 110% housing renovation subsidy will cost Italian taxpayers €220 billion, roughly 12% of GDP. Despite Italy's debt of 140% of GDP, the Italian government faced little market discipline not to renew the program (even after the fiscal disaster was obvious) because investors correctly anticipated ECB intervention if bond spreads widened.

Also as a result, Europe's fiscal framework has weakened. The 2024 reform has turned the debt and deficit limits into a complex system of bilateral negotiations between the Commission and member states. The arbitrariness of the bilateral negotiation can be seen in that, of all EU plans considered, only the Dutch plan (debt 44% of GDP, structural balance -0.5%) was rejected, while the French one (debt projected to rise to 122.6%, structural balance -4.0%) was approved even before the budget was voted. As Jean-Claude Juncker admitted when asked why the Commission overlooked French infractions: “because it is France.”

Security, spending, and sustainability

There is a good reason to want to see higher government spending in the next few years: European rearmament. Such spending is necessary given the changed security environment.

The response so far has been a (for once, appropriate) loosening of fiscal rules: the European Council endorsed measures to finance military spending increases by activating the escape clause of the Stability and Growth and hence allowing member states to spend beyond the fiscal rules. Germany's response includes a remarkable shift to accommodate a necessary increase in defense spending from 1.5% to 3.5% of GDP by 2027, excluding all defense expenditure over 1% of GDP from the debt brake (hence also making space in the budget for 0.5% of additional social expenditure or tax breaks). Together with a €500bn infrastructure fund (of which €100bn is for climate, as a concession to the Greens) and state level loosening of fiscal constraints, Germany will experience a huge increase in the deficit to nearly 6% of GDP.

More defense spending is necessary. But it comes on top of a system of incentives that have given us higher debt, fewer reforms, and lower economic growth than what would have been possible. In the short term, this is a cross we must bear. In the longer term, the current system is not sustainable. There is no question a large German deficit is necessary – temporarily. Permanently funding defense permanently as an “off-balance sheet” item by keeping it out of fiscal rules is untenable. Permanent expenditure must be paid out of permanent income – a reduction in social spending or a tax increase will soon be necessary.

Security will only be credible if backed by a serious budgetary commitment. Military capacity means little if a country can't sustainably finance it.

Europe needs to learn from South America. Delaying hard choices around spending seems attractive until the very moment that real interest rates and inflation start climbing. Many nations have already discovered through painful experience that economic stability is a prerequisite for security and social progress; it would be extraordinary for Europe to go through that experience again now.

The irony is quite striking. For decades, institutions like the IMF prescribed fiscal discipline, independent central banks, and open markets to Latin American nations — often over fierce political opposition. Now previously responsible economies (both Europe and the USA) are abandoning these principles while their former students maintain them. Facing aging electorates who demand more services with fewer working-age taxpayers, the ‘money tree’ behavior of old Latin American populists is proving dangerously appealing to Western politicians.

When left-wing leaders like Boric embrace fiscal stability, they aren't betraying their values but ensuring they can be realized over the long term. European and American policymakers would be wise to heed this lesson before they learn it the hard way.

I thank Andrés Velasco and Alejandro Werner for useful comments on an earlier draft.

1. He ran a fiscal surplus from 2006 to 2013, but then started increasing deficits in 2014, to reach 8.3% of GDP in 2018. Bolivia is now on the verge of a fiscal crisis.

2. It is always good to remember that, as Simon Kuznet’s observed “there are four types of countries, developed, underdeveloped, Japan and Argentina.”

3. Obviously, the institutional deterioration is much worse in the US. To restrict our attention to fiscal policy, making the US fiscal arithmetic work requires various accounting maneuvers, including altering budgetary baselines to make tax cuts appear cost-neutral and obscuring legislation's true fiscal impact. Eliminating limits on reconciliation procedures while simultaneously pushing massive tax cuts with no offsetting spending reductions will drive the country’s debt-to-GDP ratio (which has already risen from 91% in 2010 to 123% in 2023)significantly higher. The dollar's reserve currency status shields the US from immediate consequences, but this protection isn't unlimited.