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Economy B. C.*

Economy B. C.*

(*Before Cardoso)
The public sector has played a crucial role in Brazil’s economic
development. Nowadays, most economists agree that the country’s economic crisis is linked
to the chronic public finance imbalance that has become the greatest obstacle to
macroeconomic stabilization.
By Roberto Macedo
and Fábio Barbosa

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

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

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

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

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

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

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

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

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:

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

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

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

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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