The Lack of Fiscal Consolidation in an Inflationary Economy: Uruguay 1970-2006

Abstract

Different from the papers presented in this session, this one analyzes the lack of fiscal consolidation within a framework of tensions between the objectives of consolidation and price stability. By using a model of time inconsistency with fiscal objectives and a Government’s budget constraint similar to the Uruguayan one, it is shown that the existence of nominal debt in domestic currency and the possibility of reducing real expenditure generate incentives in addition to seignorage for the fiscal use of inflation, avoiding a more lasting consolidation process. By analyzing Uruguayan data between 1970 and 2006 it is evidenced how the real adjustment of Primary Expenditure through inflation has been the key in the fiscal stabilization episodes of the past 35 years. Through the analysis of episodes, correlations and OLS regressions, it is shown that inflation acceleration has played a major role in improving the fiscal balance owing to its effect on real expenditure. Nonetheless, such improvements have been transitory, while real expenditure has bounced back once the adjustment phase was over. This paper offers an institutional reading, since it suggests that the setting of inflation objectives by the Government together with a bias against fiscal consolidation may result in a relative high inflation level.