Opinion – Bernardo Guimarães: Sensitive markets and the role of expectations

Expectations about fiscal deficits and the government’s balance sheet have dominated economic news. High deficits lead to higher debt and may generate higher risk premiums or inflationary financing in the future. This negatively affects investment decisions and, consequently, the output of the economy today.

This argument, all over the papers, explains why the dollar and stock prices react to changes in expectations about fiscal balance.

It is possible, however, that this is only part of the explanation.

In some situations, expectations about the economy can be self-fulfilling. This implication appears in economic models based on common and orthodox assumptions.

The mechanism, in a very simplified form, is as follows:

Suppose everyone believes that the next few years will have low risk of a debt (or inflation) crisis, substantial capital inflows for investment, and robust GDP growth. With these expectations, it is easy to roll over the debt at a low cost and attract capital, which brings good prospects for growth. With a higher GDP, we collect more and the risk of a crisis is very small.

With the same fiscal effort, but worse expectations, we would have less capital inflows, less investment, and a smaller product, generating a greater risk of crisis and a higher risk premium. Bad expectations would lead to bad results consistent with expectations.

Of course, the fiscal deficit directly affects the tax collection possibilities, but the point is that different realities, guided by different expectations, can be possible with the same economic fundamentals.

This is a theoretical possibility. In practice, it is difficult to know whether such a mechanism is operating. But the theory does offer some clues.

One implication of these theories is that if economic fundamentals are good enough (fiscal surpluses, good growth prospects, very low risk), this mechanism does not operate. We need to be in a situation where the risk premium (or the inflation expectation) affects and is substantially affected by the fiscal result.

In such a situation, in which different realities may be possible, sudden changes in expectations may occur and affect the exchange rate and the Stock Exchange index.

The market is very sensitive.

And what affects these expectations?

In economic models, information that is widely disseminated plays a fundamental role, appearing on the front pages of newspapers and reaching everyone. Even if they don’t have as much content, this information strongly affects asset prices.

A phrase from the president of the republic may have a greater effect on expectations than concrete measures, which are difficult to understand and less widespread.

The reason is that widely disseminated information doesn’t just affect what I know: it also affects what I know about what others know. What is on everyone’s lips and on the front pages of newspapers ends up coordinating expectations about the economy.

In situations like this, acts and words of political leaders not only communicate the direction of public policies, but also guide feelings about the economy that affect reality itself.

In this scenario, governing in the face of negative expectations is like traveling in a leaky canoe, paddling against the tide. So, speeches and measures must be chosen carefully to coordinate expectations of balance in public accounts and little macroeconomic risk.