Fiscal crisis in Brazil: a tale of two inflations - João Ricardo Mendes Gonçalves Costa Filho

Surviving an impeachment will be a herculean task for Dilma Rousseff. With economic contraction and growing expenditure, the fiscal deficit will increase. There is no more room for gambling.

The economic situation in Brazil is far from satisfactory. After dealing with (hyper) inflation in the 1990s and income distribution in the 2000s, the next hurdle is how to grow again. And this time Brazilian society cannot avoid making tough decisions to pledge a better future. If there is no action, the current (long) recession will very rapidly become a fiscal crisis. The exchange rate will depreciate further (and fast); interest rates will soar; investors will lose trust in Brazil and the rating agencies will have, yet again, to degrade the country. Is there a way out? Yes. But it is a difficult one. 

Postponing the tough decisions

In the 1980s, the issue was a fiscal one. After being hit by two oil shocks, a careless fiscal management generated a major problem: there was no cash for paying debt. Blowing its problems away was no cheap strategy, and it took its toll. For some countries under the weight of the “original sin” (and Brazil is one of them), external debt can only be paid in foreign currency.

This question solved, hyperinflation overtook the macroeconomic agenda. Brazil managed to win this battle with a mixture of orthodox recipes and a heterodox approach: fiscal tightening, commercial opening (with an exchange rate peg) and two simultaneous currencies. The old one carried the heavy burden of inflation and new one eventually became the current “real”.

By stabilizing the economy, Brazil was able to tackle the next problem in the 2000s: income distribution. Social programs were either enhanced or created, and this was at all possible because controlling inflation is a major social program. Brazil grew on the basis of a number of factors: a rise in the terms of trade; the absorption of commodity exports by China; microeconomic reforms completed in the late 1990s and further reforms until 2005; plus other features such as incorporating the idle capacity of the labor market into the productive economy. More people were consuming, the economy gained some efficiency, and everything was fine. This is a part of the problem.

In 1988, Congress drafted the current Brazilian Constitution. Among other things, the aim was to mimic some sort of European welfare state. In order to do that, more than 90% of government expenditure is now inelastic, which means that any changes should be discussed and agreed to in Congress (in both the Lower House and the Senate). This entails investing political capital in negotiations and usually coming to a trade-off affecting benefits of those who voted for you. Incentives are designed in such way that any politician wants to avoid budget changes. This is exactly what politicians did.

Given that the country’s economy was growing, why bother then to discuss, for example, the increasing expenditure on social security benefits, particularly in a country that is still “young”, even though it is aging very fast? Over and above the level of government spending, the growth index is a problem. Actually, it is the problem. According to the Brazilian Constitution, the growth of a number of expenditure items is predefined. If the minimum wage rises, so does the lowest layer of social security benefits. And the rule currently in force is that the increase of the minimum wage is determined by the added sum of real growth in the previous two years, plus consumer inflation. Even in the absence of real growth, consumer inflation can trigger a minimum wage increase, something that in turn causes other expenses to rise.

This dynamics was set up in 1988 and Brazil was able to manage its balance-of-payments problems in the 1990s, its blackouts in 2001, its troubled elections in 2002, and the financial crisis in 2008. Why is it, then, that the fiscal crisis is relevant today, and not five years ago?

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Source: Opendemocracy

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João Ricardo Mendes Gonçalves Costa Filho is a lecturer of the Professional Master in Economics and Finance at the Sao Paulo School of Economics/Getulio Vargas Foundation (FGV/EESP) and professor of the Faculty of Economic at the Armando Alvares Penteado Foundation (FAAP) in Sao Paulo. He is also associate consultant at Pezco Microanalysis, Brazil.