The Rescue of Brazil

Op-ed in El Pais (originally published in Spanish and Portuguese)

April 4, 2015

The Brazilian economy has all the characteristics of a country under the tutelage of an International Monetary Fund (IMF) program. The list of its economic imbalances is endless: a rampant current account deficit in excess of 4 percent of GDP, an exchange rate that has long been overvalued but that has collapsed in just a few months, a public debt ratio to GDP in a rapid upward trend, a fiscal deficit of over 6 percent of GDP despite a high tax burden, an annual inflation rate of nearly 8 percent that has unanchored inflation expectations, an accelerated growth of wages well above their very low productivity. The scandal of the oil company Petrobras, the latest in a long series of political corruption scandals, is the straw that could break the back of investors' patience, the tolerance of Brazilian citizens, and the stamina of the world's seventh largest economy. The Petrobras scandal has far-reaching ramifications throughout the economy and society, paralyzing activity and collapsing both business and consumer confidence to unprecedented levels. The mass street demonstrations of recent weeks are the most graphic example of this dissatisfaction.

Such a disaster, as is often the case, is the result of a perverse combination of outdated ideology and intellectual arrogance, masked by a buoyant economic cycle dependent mainly on exogenous and unsustainable factors, such as the commodity supercycle and the exuberant Chinese demand. The disappearance of these exogenous factors has revealed potential growth to be much lower than anticipated, probably no more than 2.5 percent. This lower potential growth points to an overheated and uncompetitive economy with an excessive and difficult-to-reduce level of public spending, which needs strong fiscal and monetary tightening to remove accumulated excesses.

The Brazilian economy has all the characteristics of a country under the tutelage of an IMF program.

Brazil positively surprised the world after the multiple crises of the late 20th century. From 2003–10, during President Lula's term, Brazil grew at an average of 4 percent. A virtuous cycle of buoyant exports, declining interest rates, and improved access to credit for a growing middle class was amplified by improved income distribution generated by increases in minimum real wages and poverty reduction programs (such as the successful Bolsa Familia, which conditions financial aid to the schooling and vaccination of children in the family and has become a global best practice). Brazil experienced a social revolution, allowing a large share of the population to leave the informal economy and enjoy employment contracts that facilitate the access to credit and to unemployment benefits, creating the middle class needed for economic progress.

President Lula achieved this progress with a mix of orthodox economic policies based on fiscal and monetary discipline, liberalizing reforms, and active poverty reduction policies. Things changed with the arrival of President Dilma Rousseff. Her government plan prioritized increasing investment from 18 to 25 percent of GDP as a vehicle to achieve 5 percent potential GDP growth—a laudable goal in a country with a clear shortage of capital.

The problem arose with the strategy adopted to achieve that goal. The strong ideological component of President Rousseff's government, and the hubris generated by the economic success of the previous decade, led to discarding economic orthodoxy and veering dangerously towards expansionist populism, adopting the so-called "new macroeconomic matrix." Rather than continuing to improve the fundamentals of the economy to reduce inefficient government spending and high real interest rates and attract private investment, the new "matrix" focused on promoting growth through interventionist policies to support investment, with strong political pressure on the central bank to reduce interest rates; acceleration of heavily subsidized public credit; and intervention to depreciate the exchange rate, including capital controls, relaxation of fiscal discipline, and manipulation of administered prices to mask high inflation. Brazil not only abandoned economic discipline but led the attacks on the economic policy stance of the G-7, with strong criticism of the Fed's quantitative easing and accusations of "currency wars." Hubris and myopia reached the point of not allowing the publication of the documents of the IMF annual review of its economy, something that even China allowed. The IMF and the G-20 silently watched this accumulation of policy mistakes, doing a disservice to the Brazilian people.

Alternative policies can be successful in very specific cases, but orthodoxy exists because the accumulated experience distills best practices. When markets began having doubts about Brazil a year and a half ago, President Lula pressured President Rousseff to return to discipline, but she prioritized her election strategy, wasting a precious year in which imbalances increased further. Now the cold facts have forced President Rousseff to recognize her mistakes, and she has appointed an orthodox, serious, and disciplined finance minister, Joaquim Levy, in an attempt to regain the lost credibility through a very tough multiyear adjustment and stabilization plan. Make no mistake, it is like an IMF program, but self-financed.

Brazil is able to rescue itself because the reserves accumulated during the past decade provide a safety cushion. But the margin of error is minimal. Opinion polls and street demonstrations reveal enormous political dissatisfaction, and political support for the adjustment program is far from guaranteed. Drought is threatening to create electricity outages in a power grid that suffers from a chronic lack of investment and regulatory rigidities. A ratings downgrade to junk could accelerate capital outflows and further hinder the financing of the large current account deficit, increasingly dependent on Chinese capital and short-term flows. Stabilization programs are the only solution in these cases and are generally hard because countries get to them late and without conviction. Excesses, arrogance, and mistakes are always costly—in Greece, Spain, or Brazil.