Economy B. C.*

In the current debate, most economists agree that the Brazilian economic crisis is linked closely to the chronic public finance imbalance that has become the greatest obstacle to macroeconomic stabilization—a fundamental precondition for long-term growth.

The public sector has played a crucial role in Brazil's economic development, notably by adopting a model of industrialization based on import substitution. In its initial stages in the 1930s, government intervention in the economy was primarily indirect; protectionist tariffs, credit and exchange subsidies, fiscal incentives, and economic subsidies were implemented to protect infant industries.

In 1942, however, the installation of the state-run steel industry, Companhia Siderúrgica Nacional (CSN), marked the beginning of more direct government intervention in the production structure. Intervention was based primarily on the creation of state-owned enterprises that produced basic inputs. These enterprises promoted the growth and diversification of Brazilian industry, in addition to other stimuli to private accumulation and efforts to attract foreign capital.

It should be mentioned that the inflation accompanying these state efforts did not reach high enough levels to compromise economic growth. A more aggressive policy of economic development was adopted during the second half of the 1950s during the Juscelino Kubitschek term, a period marked by incentives to the national and foreign private sectors and by large infrastructural investments, such as the construction of Brasilia. Each action contributed to more serious inflation. As a result, Brazil experienced economic stagnation in the early 1960s that, in combination with political problems, brought about a period fraught with difficulties, eventually leading to the overthrow of the government in 1964 and a period of military rule that would extend until 1985.

During its initial phase, military rule produced great economic successes. It implemented a stabilization and adjustment program that accelerated growth between 1967 and 1973. Again, the government took the lead role in economic development by undertaking infrastructure projects, enlarging the realm of state-owned enterprises, and stimulating private initiatives through credit and fiscal incentives.

Until 1973, interventionist strategy did not compromise the finances of the public sector, nor did it seriously affect macroeconomic stability. Successful results were obtained through the expansion and rationalization of public sector financing mechanisms—notably toward a more effective tax structure and more effective domestic financing. Improvements were made possible through the implementation of compulsory savings mechanisms, such as the Time-Service Guarantee Fund (Fundo de Garantia por Tempo de Serviço—FGTS) and the Social Integration Program (Programa de Integração Social—PIS/PASEP), through monetary adjustments, and through expansion of production that generated resources needed to finance growth.

However, the first oil shock in 1973—when oil prices increased fourfold—reduced potential consumption and investment. Events surrounding the oil shock foretold the end of an expansionist cycle that had lasted three decades without any major interruptions.

Anticipating decreasing levels of national income resulting from a deterioration in Brazil's terms of trade, the Brazilian government adopted a strategy that attempted to avoid decreases in consumption and in domestic investment. It adjusted the productive structure through an ample import substitution program in the capital and intermediate goods sectors. These sectors either received strong fiscal and credit incentives, as was the case of the capital goods sector, or became the target of massive investment by state-owned enterprises, as were the cases of the energy, steel, ant telecommunications sectors.

Despite adverse international conditions that unfavorably affected growth rates in developed countries, Brazil was able to maintain high growth rates during the second half of the 1970s. Such positive results primarily were the product of the degree of government intervention, which reversed prospects for stagnation and increased the availability of external credit, thereby permitting the continued inflow of necessary resources to finance investments. 

In spite of accelerating inflation, economic policies were relatively successful at diversifying the productive structure. Their implementation, however, resulted in an enormous increase in foreign debt. Though much of the debt was initially accumulated by the private sector, the public sector was especially hard hit since it had to accept the foreign obligations that gradually resulted from these policies. The repercussions of decisions adopted during the period also translated into an increase in the domestic public debt. In retrospect, it is possible to identify these policy decisions as the root of the imbalance still felt by the Brazilian public sector. Decisions reached later in the decade must be added as they were a response to new oil shocks and the growing burden imposed by foreign debt interest payments.

At the onset of the second oil shock, the Brazilian economy, already extremely vulnerable to changes in external conditions, was subjected to drastic increases in international interest rates derived from the new restrictions of U.S. monetary policy. Enhanced by higher external debt servicing obligations, largely taken on by the central government and state-owned enterprises, the initial impacts created more problems for an already unstable public finance sector. Later, accelerated inflation would worsen these conditions even more. Financing for public and private sectors was adversely affected in light of doubts about the future health of the country's economy. The resulting process of stagnation would contaminate the entire decade to follow—a period that would become known as the "lost decade."

Despite changes in international economic conditions, contractionary policies at the beginning of the 1980s again went unpursued except in those areas affected by a reduction in available financing. In fact, it was clear that politicians, businesspeople, workers, and society in general resisted the implementation of a strategy that could help resolve the persistent disequilibrium felt in external and public accounts.

In 1980, the Brazilian government enacted policies that seemed to run counter to what was needed for balancing accounts. The government specifically opted for the implementation of expansionist policies, accompanied by predetermined interest and exchange rates, an increase in the level of wage indexation, and the maintenance of high levels of investment in segments of the productive sector controlled by state-owned enterprises. Taken as a whole, these policies resulted in new and significant increases in the foreign debt and a strong acceleration of inflation. By 1981, the policies were abandoned and replaced by a policy based on high internal interest rates designed to encourage the inflow of foreign capital; however, an economic recession was the result.

In 1982, Mexico's declaration of a moratorium on its debt payments marked the beginning of a drastic reduction in the availability of foreign capital to developing countries. In the years to follow, developing countries could no longer count on external flows to finance the disequilibrium in the current account of their balance of payments or their public deficit. This "definancing" corresponded with a reorientation in the Brazilian economy toward the generation of a positive trade balance that would allow the government to honor its external commitments. In fact, in 1983 an adjustment program was undertaken to reduce internal demand through the implementation of changes in relative prices (exchange rate devaluation and control of nominal wage adjustments) and public expenditures.

Several measures were adopted simultaneously to preserve the productive structure developed in the previous period, including the creation of an exchange hedge for companies with external debt. This strategy, however, presupposed new internal and external commitments by the Central Bank, without the creation of mechanisms capable of assuring long-term equilibrium in public finances.

As a matter of fact, gross tax expenditure fell from a level of 26 percent of gross domestic product (GDP) between 1970 and 1975 to 23 percent of GDP during the 1984-1989 period. One of the factors contributing to this decrease was the structural narrowing of the fiscal base, resulting from an increase in exports and incentives designed to assist in the import substitution process.

Some authors attribute this reduction in tax revenues to the continuous increase in the participation of states and municipal governments in total taxes, a process reinforced after 1985 by the Passos Porto Amendment and passed into law by the 1988 Constitution. The argument holds that the increase in constitutional federal transfers has discouraged state and local governments, especially small municipalities, from pursuing effective tax collection strategies by guaranteeing resources at zero cost (even from political perspective).

The proponents of these arguments, however, cannot ignore the fact that average annual growth rates during the 1980s (2.2 percent) suffered a marked decrease from the rates registered in the 1970s (8.6 percent) that had brought about a more than proportional reduction in tax revenue growth. Additionally, the acceleration of inflation, caused by macroeconomic disequilibrium, reinforced a tendency toward loss of tax revenue; real tax revenues were eroded by its inflationary process through the so-called "Tanzi effect," which occurs when inflation and real interest rates are high, and taxpayers have the incentive to delay paying taxes as long as possible, thereby reducing the real value of tax collections when ultimately received by the government.

In the late 1980s, there was increasing evidence of tax evasion, not only as a result of an increasingly complex taxation structure, but also because of deterioration of enforcement mechanisms and "informalization" of several segments of the productive structure, processes largely associated with the stagnation of the Brazilian economy.

In addition to an unfavorable revenue situation, current expenditures increased dramatically, climbing from 9.9 percent of the GDP in 1980 to 14.3 percent in 1989. Personnel expenditures in the same period increased from 7 percent of the GDP to 9.7 percent. Sixty percent of this increase occurred at the state and local government levels due to a restructuring of the distribution of federal revenue in the 1980s. 

The country also experienced during the same period an increase in the government's financial commitments. Total expenditures jumped from 0.63 percent of GDP in the 1970-1978 period to 3.5 percent in 1988-1989, largely as a result of the domestic and foreign debt accumulation. The inevitable consequence was the draining of government savings as a source of investment financing and, consequently, the exhaustion of economic growth. In fact, government savings fell significantly over the years (and especially during the latter half of the 1980s) from 7 percent of GDP in the early 1970s to negative values in the 19871989 period.

The growing scarcity of government and foreign savings was accompanied by an equivalent reduction in total investment in the country. Total investment dropped from 26 percent of GDP in the mid-1970s to 18 percent by 1979. This adjustment was particularly visible in expenditures with gross capital formation of the public sector and its enterprises, which dropped from 12 percent of GDP in the 1970s to 6 or 7 percent in recent years. However, the contraction in investment expenditures was nearly offset by an increase in other expenditures.

There was also a significant shift in the composition of expenditures, a drastic decrease in expenditures for investment, and significant increases in expenditures for personnel and financial obligations.

Despite cuts, the public sector continued to experience operational deficits on the order of 5 percent of GDP annually. If, for the sake of comparison, this percentage were applied to today's GDP (approximately US$400 billion), these values would signify that the public debt grew by at least an additional US$180 billion between 1981 and 1989. In fact, this never occurred. A part of the deficit was financed by monetary expansion through forced reductions in government liabilities, as will be seen in the latter portion of this chapter.

In addition to inadequate financing for the needed public sector resources, there was a substantial loss in the "quality" of federal spending due to changes in its composition. The government had ceased to invest in order to cover expenditures that did not generate economic returns and were of questionable social value.

There is no doubt that the economy's capacity for future growth was compromised by limitations on expansion and modernization of the productive structure and a reduction in relative competitiveness and efficiency. At least two factors were identified as contributing to this situation. First, the drastic reorientation of the public sector away from its previous role as direct investment inducer created a gap that the private sector could not fill. Second, a significant public debt and successive interventions in the pricing mechanism and financial assets through the so-called "heterodox plans" prompted high levels of uncertainty that would further limit investments.

Because of internal difficulties and drastic reductions in external financing after 1982, the process by which domestic savings compensated for fiscal disequilibriums started to show signs of ineffectiveness. Lending terms were reduced, and real interest rates required, ex ante, to roll over the ever-expanding public sector debt began to show consistent increases.

There was a sustained and increasingly common perception that the public sector would face liquidity constraints in the short run and structural insolvency in the long run. According to Fabio Barbosa and Carlos Mussi (1991):

... in flow terms, the fiscal hiatus necessary to cover the (public) sector's commitments grew. Likewise, the principal on the debt was accumulating as a result of past deficits, and the fiscal adjustment became an increasingly apparent solution.... From a passive government activity, fiscal policy became the country's most important instrument of macroeconomic policy by the end of the 1980s. The possibility of a hyper-inflationary process reflected this situation.

Indeed, at the beginning of the 1990s, the nonfinancial component of the public sector registered an operational deficit estimated at 9 percent of GDP. Since the economy was recession-bound and showed a monthly inflation rate of 100 percent, there were no prospects for noninflationary financing. The public sector's continuous structural disequilibrium and the interruption of its financing pattern were clearly at the core of inflation and the overall stagnation of economic production.

The Worsening of Inflation
and Heterodox Attempts at
Stabilizing the Economy:
1986-1992

This section examines in greater detail the growth of inflation occurring after 1985, continuing stagnation, and policies adopted to contain the inflationary process between 1986 and 1992.

In order to understand the turn of events after 1985, it is important to recognize the serious changes that took place in the political arena. After two decades, governmental power was relinquished by the military and turned over to civilian rule. Tancredo Neves had negotiated the transition of power to full democracy successfully and was elected president by the Nation Congress in 1985. He died, however, before being inaugurated, and José Sarney, his vice president, was sworn in as the new president. Sarney brought with him a past association with the military regime and weak leadership skills. The coalition government had the ability to distribute patronage and to protect populist interests but lacked leadership. It was unable ultimately to obtain the support necessary to solve the country's dire problems.

The economic policy of the Sarney administration that ended in 1990 suffered from an inherited political fragility aggravated by difficulties in implementing measures required for economic stabilization, many of which were inevitably unpopular. All stabilization policies adopted during this administration failed primarily because of an absence of public sector structural adjustment and a restrictive monetary policy.

Ironically, the most valuable contribution of Sarney's administration—though only a perception—was the recognition that no stabilization plan would succeed unless the fiscal crisis itself were resolved. Today, there is virtual consensus concerning the reasons for the failures of the various stabilization plans.

Aside from this "positive result," changes in indexation rules imposed by Sarney's price freeze policies, associated with the volatility of inflation rates in the very short run, had a serious effect on the expectations of economic agents. From the public sector's viewpoint, the government's successive devaluation of liabilities based on drastic changes in the "rules of the game" further eroded the credibility of treasury bonds and made their transactions more difficult to carry out.

To present a better analysis of the topics covered in this section, certain developments in the macroeconomic analysis of particular countries with prolonged processes of high inflation, as well as in other economic policies, should be taken into consideration. Several Brazilian and foreign research centers believed that confronting chronic inflationary processes through the usual restrictive monetary and fiscal policies had become more complicated due to the presence of "inertial inflation," or inflationary memory as it is also called. There existed, accordingly, a process that tended to be perpetuated by the actions and beliefs of economic agents, particularly through the widespread adoption of formal and informal indexation of prices and contracts. In such an environment, the adoption of policies aimed at limiting aggregate demand became more complicated because of the existence of this inflationary inertia. The insistence on implementing such policies also exacted high social costs; an increase in restrictive policies was required to halt inflation and eradicate the inertia inherited from the past.

Notions concerning inertial inflation led to the launching of "heterodox" policies. In addition to adopting fundamental fiscal and monetary policies, the idea was also to adopt a set of measures that would embrace other policies aimed specifically at containing inflationary inertia. Included among these were the de-indexation of the economy, temporary price freezes, and the use of income policies to coordinate prices in the economy as an initial step toward stabilization. These ideas were greatly bolstered after Israel successfully adopted a similar plan in 1985. The Israeli case was widely publicized not only as a result of its impact per se, but also because many of Israel's economists are well known internationally.

It is important to keep in mind that these heterodox plans do not essentially constitute the antithesis of traditional anti-inflationary policies. On the contrary, they emphasize that the fundamentals of a stabilization plan, fiscal or monetary, must be in place before additional measures targeting expectations and price coordination that comprise the accessory component of the plan are adopted. These policies are ancillary because they cannot be sustained in the absence of fiscal and monetary fundamentals.

In Brazil, economists had extended and elaborated upon these ideas. However, their implementation by a fragile government that was incapable of assuring the maintenance of required fundamental measures resulted in many failures. There existed a series of stabilization plans believed to be heterodox. With the exception of a few measures adopted by the Collor government, these plans could not attack the fundamental issue of public sector fiscal disequilibrium, as financing the public sector ultimately led to inflationary pressures derived from its monetary impact. Since fiscal and monetary issues were not adequately addressed, policies implemented during the Sarney administration were only instrumental in bringing about temporary reductions in the inflation rate through a series of price freezes. Once price freezes were removed, the inability of the plans to tackle fiscal issues caused inflation to reach even higher levels.

The Cruzado Plan, the first of many, was perhaps the most frustrating. Because of Brazilian society's belief in the plan, it brought great relief to the economy, although for a brief period, and represented a favorable moment for the adoption of fundamental fiscal and monetary measures. President Sarney and other politicians around him, however, were so euphoric about the popularity and success of the Cruzado Plan that they ignored the warnings of economic advisers and others who had participated in the debate. Lacking the necessary fundamental measures, the plan ultimately failed. The effects of the Bresser Plan, next adopted in the midst of greater skepticism, were fleeting. It failed due to a lack of political support for implementation of fundamental measures. Later during Sarney's term, a Summer Plan was also implemented that was basically an attempt at keeping things under control. It was already clear that further drastic measures could not be adopted so late in Sarney's term of office.

Under the Collor administration, plans were considered that were incapable of stabilizing the economy but had basically different results. Inflation never returned to the formerly higher rates of the previous administration and, on the contrary, experienced a decrease....

The stabilization plans of Sarney's administration were limited to their ancillary component. In other words, they were limited to the interruption of inflationary inertia through price freezes, de-indexation, and "monetary reforms," measures that were restricted to the creation of new currencies by means of the elimination of digits off the old currency. These measures and the creation of new currencies are often essential in Brazil sine high levels of inflation result in excessively high (and difficult to manage) nominal values in common economic transactions, especially in the financial sector.

Past promises to address fundamental issues, particularly the issue of public debt, were nothing more than empty words. The fact that disequilibrium was permanently intensified shows that promises were not honored. Besides a worsening of the economy during the period 1986 to 1989, it was also understood that if nothing was done, the public sector deficit for 1990 could reach 9 percent of the GDP. After 1990, the operational deficit suffered a significant decline. The Collor government had reoriented its economic policy in terms of formulation as well as of implementation. 

When Collor was inaugurated, the country's economic and financial situation was in a state of chaos, and the economy faced imminent hyperinflation. A large part of the growing public deficit was financed through an expansion of the money supply. Transactions were performed at increasingly shorter intervals because of uncertainties permeating the market. Shortly after Collor's inauguration, the new administration adopted drastic measures, including taxation and a freeze on financial assets to reduce the economy's liquidity and generate resources for the budget. Prices were frozen, indexation mechanisms were attenuated, and the government attempted to reduce the number of employees through administrative reform. The sale of public assets through patrimonial reform was contemplated in order to reduce the deficit. Other measures aimed at deregulating the economy were also implemented, including a tighter control on expenditures in terms of operational expenditures and in terms of personnel costs in particular. All of these measures were part of Collor Plan I.

These measures completely eliminated the public deficit as well as reversed it into a surplus in the federal budget in 1990 and 1991. Although positive, the results stemmed from short-term adjustments that failed to address some additionally important problems. Furthermore, many administrative aspects in the implementation and enforcement of new measures were extremely problematic.

The government was soon faced with strong pressure against the withholding of financial assets. Policies were therefore relaxed, which resulted in weaker monetary control. In addition, the government could not effectively control state-owned enterprises. Due to political pressures exerted around the time of the senatorial and gubernatorial elections in 1990, state banks, for example, extended credit operations above and beyond permissible levels. Patrimonial and administrative reforms were also discontinued. Expectations were high because economic agents knew that the fiscal adjustment had not been consolidated. A large portion of adjustments had been implemented exclusively on that one occasion only and would not be repeated.

By the end of 1990, expectations and the inertia behind fiscal and liquidity pressures had driven inflation once again on an upward course. Rising inflation rates sparked a renewal of government measures, including price freezes, containment of liquidity, and the creation of specific short-term funds. The economy entered 1991 with prices frozen and without any clear-cut indication that the basic factors causing the inflationary process were being effectively eliminated. The failure of Collor Plan II, together with several other problems, discredited the administration's team of economic advisers and forced them to leave office in May 1991.

The basic policy orientation taken by the country's new Minister of Economics, Marcílio Marques Moreira, was to unfreeze prices, take effective steps toward liberalizing the economy, renegotiate foreign debt, and proceed with structural reforms. Emphasis was given, for example, to the privatization of state-owned enterprises and fiscal reform that would aid the consolidation of prior adjustments made by the Collor administration. Prior to the consolidation of these adjustments, the government focused on expenditure control and monetary policy, both of which played particularly important roles in bridging the prevailing conditions with future conditions after fiscal adjustments were consolidated.

Despite opposing pressures and despite predictions made by the press and economic agents that the new team of economic advisers would resort to price freezes because they lacked alternatives, the policy was pursued persistently during the course of one year, from May 1991 to May 1992, and a series of measures were adopted that represented tangible advances toward stability and structural reform.

Collor's new team of economic advisers initiated a privatization program, established mechanisms that allowed for the financing of a larger agricultural supply, adopted several measures to reduce the bureaucratization of the economy, and advanced trade liberalization and negotiations of sectoral agreements aimed at increasing the economy's productivity an competitiveness. Also addressed were foreign debt problems. Agreements were obtained with the International Monetary Fund (IMP) and the Paris Club and negotiations established with private banks. The team of economic advisers advanced the reformulation of insurance systems and adopted a new wage policy that reduced the previous policy's impact on public finance, especially on social security. A policy was implemented to attenuate the disequilibrium and contain expenditures on the fiscal side, while supporting high interest rates that maintained financial assets invested as such.

Although the high interest rate policy and the contraction of expenditures were agenda items, it was recognized that their effects would be limited since high interest rates would eventually compromise fiscal equilibrium by reinforcing a growth in the debt. High interest rates also generated a large

influx of foreign resources that affected the economy in two ways: the country's supply of foreign currency increased, while the Central Bank had to negotiate bonds at higher interest rates in order to contain the liquidity resulting from that same influx of foreign currency. The monetary control mechanism was, therefore, only partially effective because, accompanied by a return of withheld cruzados, a large inflow of foreign capital, and substantial trade surpluses, it acted only as a conduit that would eventually lead to needed fiscal adjustments.

Congress began to negotiate projects aimed at bringing about fiscal reforms that were seen as crucial in gaining economic agents' confidence in the government's financial situation. With their trust, it would be possible to pursue lower interest rate policies that would, in turn, stimulate the economy and generate demand for external resources that could be covered by accumulated reserves.

Once prices were liberated, inflation reached a monthly rate of approximately 25 percent toward the end of 1991. Prices decreased during a period before April 1992, except for a seasonal increase observed in January. As demonstrated by the price indices, various indicators showed that inflation fell to 20 percent monthly in April 1992. According to the team of economic advisers, this signified that success was indeed possible if fiscal reforms were to consolidate the progress that had already been made and if problematic monetary factors were successfully removed. 

At this time the government had undergone an extensive ministerial reform. Discredited ministers were replaced by ministers with national recognition, resulting in an improved Collor administration vis-à-vis its political supporters in Congress. Reform helped the administration to obtain approval for a new wage policy and various important projects, such as port reform and public service concessions.

In mid-1992, however, this path was challenged when accusations of corruption against President Collor surfaced. Forced to step down in October 1992, Collor was impeached in December 1992. The fiscal adjustment debate already before Congress was interrupted, and no subsequent projects were approved. During this period, two factions emerged within the Collor administration. On the one side, the economic team continued to press forward and insisted that expenditures needed to be contained and that fiscal reform was still necessary. On the other side, factions tried to use public sector resources as a way to obtain support for their campaign to prevent the president's impeachment.

The internal dispute between the economic and political sectors of government did not compromise public finances significantly. However, given the pessimistic atmosphere and growing public disbelief in the ability of the government to promote fiscal reform, prices increased again to levels of 25 percent per month. Recession intensified as entrepreneurial and consumer confidence plummeted even further because of the proliferation of negative press reports. Amid these conditions Itamar Franco was sworn in as provisional president of the country in October 1992.

Measures Adopted by the
Itamar Franco Administration and
the Current Economic Status

In order to understand the economic policies of the Itamar Franco administration, it is necessary to remember that his government came in under forces that differed from Collor's on economic policy. As a result, one faction within his government was willing to make greater fiscal concessions, wanted to see the immediate recovery of economic growth, and proposed nominal wage increases. Another segment wanted fiscal reform and supported economic policies that were more in line with those of the previous government. The president himself espoused a conflicting position. Based on his own words, one can easily conclude that controlling inflation was not his top priority. He was more concerned with achieving economic growth, lowering interest rates, and attacking poverty. Franco's philosophy on the nation's modernization and the role of the government differed from the previous administration and was more in line with an interventionist approach.

During the provisionary period, from October to December 1992, the Franco administration divided up the Ministry of the Economy. The ministry previously encompassed the ministries of planning, finance, and industry and had been able to control economic policy in a unified manner. The Ministry of the Economy was also responsible for wage policies. Once the division was made effective, economic policy was conducted by the segment willing to make concessions, particularly the Ministry of Labor. Such concessions were made as a result of the conflicting forces in the area of wage policy: the government increased bimonthly adjustments, extended the adjustments to include a wider range of salaries and social security benefits, and expedite settlements in pending labor cases.

Together with a rise in positive consumer expectations after Collor's impeachment, measures sparked an increase in economic activity that led to greater demand for money and placed pressure on prices. By February 1993. the inflation rate had increased to 30 percent monthly from a previous rate of 25 percent.

On the fiscal side, the government was unable to pass the strongest measures (originally proposed by the previous government) through Congress. The only measures passed were some minor modifications in the corporate income tax structure adopted in 1992. Moreover, Congress, during a first reading, had already approved a new tax on financial transactions (Imposto Provisório sobre Movimentações Financeiras—IPMF), proposed during the Marcílio Marques Moreira period. Marques Moreira had proposed that the IPMF be a social contribution that would substitute for other taxes and not an object of earmarked expenditures. As approved, the IPMF includes a provision that 38 percent of its revenues be spent on education and housing. Additionally, it was not substituted for any other taxes. The modified version of the tax would pass a second reading and become effective as of the second half of 1993. With these changes, however, the public's lack of confidence in the government's ability to implement any effective fiscal adjustment was reinforced. Discussions of fiscal reform would apparently be postponed until the end of the year, at which time Congress would address the issue of constitutional reform.

In terms of structural reform, the privatization process was redefined, thereby causing the government to lose its credibility to follow through on its commitments. On a more positive note, however, the port reform proposed by the previous administration was approved, resulting in the adoption of a more liberal posture vis-à-vis private investment in port development and personnel hiring policies. The port reform involved such substantial reform that not even a military administration was able to adopt it.

Regardless of its positive accomplishments, the Franco administration was unlikely to succeed in implementing an effective solution to Brazil's fiscal problems without overcoming contradictory forces within the federal government and without clearly defining an anti-inflationary policy. Franco's mandate was short and culminated in congressional, senatorial, gubernatorial, and presidential elections in 1994. Franco's provisional government was not likely to stabilize the economy in such a short period of time unless it succeeded in carrying out a profound reorientation.

The situation could have led to two alternative scenarios. Although not committed to combating inflation, the government, on the one hand, might have refrained from engaging in destabilizing policies. The Franco administration did inherit certain favorable conditions from the Collor administration (a smaller deficit, reduced internal debt, and larger international reserves) and did have a viable set of stabilizing policy options. There was a possibility of correcting, ex post, the short-term public debt. This was carried out ex ante, generating uncertainties that increased interest rates and debt service payments. Since the country held a surplus of foreign currency, another policy option at its disposal was to adjust exchange rates. In a second scenario, the government might have opted for expansionary policies in an effort to resume growth. Here the administration risked the possibility of pushing the economy onto the recurring inflationary path that plagued the Sarney administration.

The first of these two scenarios depended heavily on the approval of the IPMF and on constitutional reforms scheduled for the end of 1992.

Inflation and Stagnation

In its initial stages, inflation was a disease that the economy could cope with; the implementation of indexation mechanisms, in particular, effectively tempered its effects. Moreover, the engine of economic growth, the state, did not encounter any difficulties in financing itself. At one time, monetary indexation was an important tool used by the military government to assure the financing of the public sector. Prior to that time, the government issued bonds without indexation, which the financial market was forced to accept.

With the evolution of this process, as well as with the successive measures designed to combat it, and an interruption in financing flows, inflation became dysfunctional. First, growing inflation discredited indexation. Different adjustment indexes emerged, and economic agents began to search for better indexation mechanisms. Second, price indexes always lagged behind inflation, especially when the inflation rate accelerated more rapidly. As a result, indexation based on ex post facto indexes was insufficient to assure that nominal values would be appropriately adjusted despite a shortening of intervals between adjustments.

Third, and perhaps most important, the successive measures adopted by the government to combat inflation and to solve its financing problems generated mistrust among economic agents, who, in turn, responded by not saving and decreasing available financing for the government sector. This mistrust emerged because on various other occasions under different economic plans, indexation mechanisms were interrupted. Following the procedures in existence since the 1970s, the government interfered with indexes by purging price increases, redefining their weighting system, and carrying out other measures that resulted in serious losses to economic agents who held financial assets at the time.

Fourth, intervention became more audacious at each turn, culminating with the confiscation of financial assets tied to specific taxation policies carried out during the Collor administration. Economic agents, therefore, became reluctant to finance the government sector because of uncertainties, this became the main reason for rising interest rates. The consequences were twofold: the state deprived itself of the financial resources needed for its investments, and private creditors suffered losses, causing savings to contract and reducing money available for investment in the private sector.

The inflationary problem in Brazil and its repercussions on the rate of investment and economic growth may be best understood if the public sector is viewed as a private enterprise that had filed for Chapter 11. By extending this analogy further and likening it to a poorly resolved Chapter 11 case in the private sector, the government, in experiencing chronic deficits and debts, had no other alternative than to proceed as enterprises in this situation typically do: "clean house," by balancing revenues and expenditures—fiscal reform—and negotiating debt payments with creditors, eventually sacrificing assets, particularly state-owned enterprises, via programs of privatization. Contrary to expectations, the government did not "clean house." By failing to refinance the debt and by forcibly liquidating its liabilities by intervening in indexation mechanisms until it finally resorted to the confiscation of society financial assets, the administration lost credibility and caused its lender significant monetary losses.

In order to resolve its problems effectively, the government's first task should be to balance its revenues and expenditures. The tax structure is less than perfect, and tax evasion is a pervasive problem. At the same time, the government must promote cost containment and restructuring measures by limiting its expenditures to necessities, such as road maintenance, and by stopping the enormous waste of resources taking place in the form of political concessions, ill-defined investments, and current expenditures on unsustainable privileges such as full-salary retirement pensions.

The debt should be restructured by reducing interest payments and by lengthening the maturity period, provisions that were only recently adopted with foreign creditors. Internally, fiscal reform and the sale of government assets clearly might be sufficient to cover debt service, which would result in an increase in credibility that could open the way for negotiations to reduce interest rates and extend repayment schedules. It is particularly important that the privatization process be resumed. The government would be following those enterprises that have filed for Chapter 11: disposing of assets as a way to reduce liabilities.

It is worth noting that intervention in indexation mechanisms resulted in vast gains for those who had financed their housing purchases and for those who had financed industrial, agricultural, and regional development through the banking system. These gains, however, seriously impaired new investments. The funds were not renewed for additional lending, and their growth was threatened by stagnation and a retraction in savings.

One important question related to the root of the Brazilian inflation and stagnation problems remains to be answered. No rational solution has been found for this poorly resolved Chapter 11. The frustrating experiences with plans and teams of economic advisers have demonstrated that the problem is conditioned by institutional and political elements. In its five hundred-year history, Brazil has evolved through consecutive economic cycles that began with timber extraction, were followed by sugarcane, cotton, gold, and coffee extractions, and, since the middle of the twentieth century, have been based on import substitution industrialization. These cycles took place in different regions and resulted in demographic and productive bases that are wide dispersed throughout the country. Heterogeneous interests committed to the maintenance of these bases were also formed, as is the case of sugarcane in the Northeast and coffee in the Southeast.

Paralleling these economic cycles, the country received successive waves of immigrants of different ethnic origins who mixed with the local population and formed a new population of racially mixed groups. Add to these factors the vastness of the country's territory. Taken altogether, these factors prevented the creation of an hegemonic force within Brazilian society, be it political, ideological, ethnic, or even religious, that could clearly define a stabilization program and gain support for it. In general, previous experiences show that ancillary measures of heterodox plans, such as price freezes, find strong support among politicians. However, when the policy aims at the root of the problem, such as fiscal control, several interest groups switch sides, thereby leaving the stabilization plan without any chance of success.

After a series of military administrations, civilian leaders came to power. However, even if a government is in favor of structural reform, as was the case of the Collor administration, any structural reform program that involves fiscal adjustment is bound to face opposition. As reform measures are presented to Congress, it reacts as an advocate of vested interests, be they personal, familial, regional, local, or corporate.

Once elected, Collor had a political hedge. He exhausted it, however, by seeking congressional approval for measures such as price freezes, the withholding of assets, and the adoption of specific taxation policies.

When the fiscal reforms proposed by Marcílio Marques Moreira were presented to Congress, they were immediately rejected. Eventually, the government was able to negotiate the approval of some higher taxes, although these measures were of dubious efficacy. The tax reform as a package was never approved, and the proposal to cut government expenditures was completely ignored. The approval of a few new taxes was conditioned on using proceeds partially to cover programs in education and housing.

The frustrating aspect of the whole situation is that the country is losing time in its race toward development and has already lagged behind many other countries. These frustrations explain why so many observers, Brazilian and foreign, have adopted a cautious "wait and see" attitude. They are concerned that the Brazilian case is too complicated to be fixed readily, but also that Brazil is too large to be ignored.

Excerpted from The Brazilian Economy: Structure and Performance in Recent Decades edited by Maria J. F. Willumsen and Eduardo Giannetti da Fonseca, North-South Center Press, University of Miami, 288 pp.

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The Brazilian Economy: Structure and
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288 pp