Keith F. Houston
Dr. B. Malamud
ECO 460.01
12/06/03
The Failures of Brazilian Currency Reform
The Economy of Brazil is the seventh largest economy in the world. The International Monetary Fund recently provided a stimulus for the second time in less than ten years because the failure of the Brazilian monetary system would have drastic effects for all of Latin America.
From 1986 to 1994, Brazil had six separate currency reforms known as Cruzado (1986), Bresser (1987), Summer Plan (1989), Collor 1(1990), Collor 2 (1991) and Real (1994). Each plan meant to stabilize the Brazilian Currency (Cruzeiro) until finally it was replaced by the Real in 1994. This paper will first look at the basic factors that led to the implementation of each plan and their subsequent failures and be followed by a deeper analysis.
Brazil was ruled by the military from 1964 until March of 1985. The country did well under military rule until the oil shock of 1973. The economy remained in crisis throughout the 1970’s and the public began to demand civilian rule. A civilian government was to take control under President Elect Tancredo Neves, however, Neves died of natural causes before taking office and the Vice-President Elect, José Sarney was sworn in. Sarney was tied to the outgoing military regime and did not have the support Neves had.
Sarney’s first attempt at currency reform came in 1986 with the Cruzado Plan after inflation had risen to 200% in 1985 after two big recessions in 1981 and 1985. The following quote from Luiz Carlos Bresser-Pereira shows how the problems from the oil shocks of the a970’s were made worse by the government.
At that time monetarist economists believed that in order to control the high rates of inflation in Brazil the only solution was to reduce the public deficit and the money supply, therefore cutting public and private aggregate demand.
Sarney’s plan “was to adopt a set of measures that would embrace policies aimed at containing inflation inertia such as de-indexation of the economy, temporary price freezes and the use of public income policies to coordinate prices in the economy.” (Macedo & Barbosa). Sarney’s government sold the plan to the public and it was initially a huge success due primarily to the public’s confidence in the plan. The government’s strict enforcement of the price controls led to some goods being with held from the market and market corrections caused inflation to rise to over 400% by 1987.
Sarney’s next pushed the Bresser Plan named after Finance Minister Luiz Carlos Bresser-Pereira who refers to it as the “1987 Plan”.
We intended, with the freeze and with a devaluation of the Cruzado, to overcome the deep economic and financial crisis that the beleaguered Brazilian economy was facing in the second quarter of 1987. And this objective was basically achieved. There was no intention of “solving definitely” the long tern crisis of the Brazilian economy – but the objective of overcoming the acute crisis of the moment was essential to the 1987 Plan. (Bresser).
The plan was to stop the free fall of real wages that had occurred but the protesting of the working class to what they perceived as a “wage compression” caused inflation to again spin out of control. Workers had lost real income during the last months of the Cruzado Plan due to producers raising prices at a faster rate than they raised wages. The Bresser Plan failed because the wage indexation being used was not understood by the public who began to associate their real wage losses under the Cruzado Plan with the Bresser Plan. This led to the final attempt at currency reform under Sarney, the Summer Plan of 1989, which desperately tried to solve the inflation problem but ultimately led to Sarney being replaced with Collor Administration in 1990.
The first Collor Plan was brought into place due to the threat of hyperinflation caused by the increased financing of government through increases in the money supply. The plan aimed to increase taxes, reduce liquidity by freezing financial assets and generate revenue for government expenditures. The plan was initially successful at eliminating the government’s deficit spending and even brought about a surplus, however, the freezing of financial assets was lifted and the inflation problems returned.
The second Collor Plan meant to fix the economy by freeing financial assets and discontinuing the price controls instituted under Sarney. This plan failed and led to Collor leaving office in October of 1992 and being impeached two months later in December.
The Real Plan was implemented in 1994 and replaced the Cruzeiro with the Real. The new currency was pegged to the US$ and an appreciation of the currency was expected. The plan also aimed to eliminate the indexation of the economy and gradually reform monetary policy. These policies had the effect of bringing inflation down to almost zero as shown in the graph at the top of the next page.
Because domestic interest rates were higher than those outside Brazil, the government began to borrow on the world market to keep its interest costs down. This led to a higher than normal debt for the government when the Real began to depreciate against other currencies which led to the two IMF bailouts.
The primary problem with the Brazilian economy is the distribution of income. During the six currency reforms, the GINI coefficient for Brazil was at .60 while the average for the countries of Argentina, Bolivia, Chile, Columbia, Costa Rica, Mexico and Panama was .42. Inflation worked as a tax upon the poor because their wages were not increasing at the same rate prices were. The government, like most governments, was (and still is) run by politicians who are loyal to their primary campaign contributors.
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 throughout the country. Heterogeneous interests committed to the maintenance of these bases were formed. (Macedo & Barbosa).
A very small proportion of the population controls these industries but this small proportion holds the keys to power. This small population gained most of their money and power by using slave labor. The poor of Brazil remain that way because the people in control are using their power to keep wages low and profits high as they were when slavery was legal. The failure of the first five currency reforms were due primarily to the elite demanding that the politicians they helped elect do something to stop the flow of their money from them to the poor of Brazil. The rich cut back their private funding of increases to government spending and this led to higher interest rates and higher inflation. The government also had trouble with tax collections during this period because people would delay the paying of their taxes as long as possible in order to have lower real taxes (The Tanzi Effect). Inflation also resulted in the indexation measures used by the government to become untrustworthy because the price indexes did not appear to reflect the rise in inflation.
The Real is now on a crawling peg but this can lead to the belief of an overvaluation of the Real because of the public’s perception that the Real’s value will fall due to the government’s previous history. The government is now under control enough that it is not easy to finance increased government spending by just printing more money which has slightly helped the public’s confidence in the Real. The government still has problems balancing its budget and limiting costs on its expenses which takes away from the public’s confidence in the Real and the Brazilian economy.
Many researchers have come to the conclusion that Brazil must implement at least these five changes in order to maintain a stable economy:
- Privatization of state owned businesses,
- Maintaining a free floating currency,
- No controls on capital flow,
- Improved fiscal discipline and
- The promotion of economic growth.
The IMF has made several of these required as a condition of its second bailout in under ten years of the Brazilian economy. Only a true revolution of government, which gives the majority of Brazilians power over the strong interests of the elite and keeps the majority from overcompensating for years of repression, will result in these changes.
Macedo, Roberto and Barbosa, Fábio Economy B.C. : Before Carduso
Bresser-Pereira, Luiz Carlos Brazil’s Inflation and the Cruzado Plan, 1985 – 1988
Dornbusch, Rudi Brazil’s Incomplete Stabilization and Reformweb.mit.edu/rudi/www/media/PDFs/brazil.pdf
Clements, Benedict The Real Plan, Poverty and Income Distribution in Brazil