Brazil’s transformation from economic problem child to poster child is remarkable. The Lula administration’s key strategic insight was that lowering inflation and increasing economic stability, albeit at the expense of lower short-term economic growth, can be politically and electorally rewarding. What in 2003 may have looked like an emergency response to contain the financial crisis and avert a sovereign default has become the cornerstone of Brazilian economic policy and the main reason why Brazil is weathering the global crisis relatively unscathed.
Brazil’s transformation from economic problem child to poster child is remarkable. After averaging a mere 2.5% in the decade before 2003, annual real GDP growth picked up to 4.7% during 2003-08. Given global headwinds, it is doubtful that Brazil will continue to grow at this pace, but growth of around 4% over the next decade is achievable. After experiencing repeated crises throughout the 1980s and 1990s and as recently as 2002, Brazil’s economic and financial resilience is today almost second-to-none. Following Fitch and S&P, Moody’s is about to award Brazil an investment grade rating. True, the economy is forecast to contract slightly this year. But not only do the fundamentals remain strong, the economic contraction is also much less pronounced than in many other emerging and developed(!) economies and a return to sustained growth is just around the corner.
Brazil has come a very long way. In a previous comment, we attributed Brazil’s resilience and quick rebound to the reduction in foreign-currency mismatches, increased FX reserves and a disciplined fiscal policy. We perhaps should have added to the list the resilience of the banking system, the de facto independence of the central bank and a strong and credible commitment to economic stability. However, it is also a well-known fact that economic policies in the run-up to the crisis were far from optimal. It would undoubtedly have been preferable to contain the increase in current government spending, fuelled by buoyant tax revenues. This would have supported a more rapid decline in government debt and interest rates, thus allowing for a greater increase in private sector investment and faster economic growth. This might have helped to contain (if not avoid) the overheating pressures that emerged in 2004 and 2007 (and the subsequent monetary tightening in 2005 and 2008). Such a policy would also have given the authorities greater scope to pursue counter-cyclical fiscal policies today.
It is no secret either that the Lula I/ II administrations have been far less successful on the structural reform front. A limited public sector pension reform at the very beginning of Lula I has been the most eye-catching reform thus far, although several smaller reforms have been passed. The list of desirable structural reforms remains very long, including further pension reform, labour reform, central bank autonomy, tax reform, education etc. With the president’s second mandate drawing to a close, it is very unlikely that anything major will be achieved before the next president takes office in 2011.
 |
| Source: IMF |
Why did macroeconomic reform take place, while microeconomic reform did not (or barely)? The answer to this question is multifaceted. First, the government has much more control over fiscal and monetary policy than over structural reform. Structural reform requires support from a great number of political “veto players”, including, most crucially in Brazil, a fragmented and difficult-to-control congress. Second, the political cost-benefit analysis made macroeconomic discipline much more enticing and rewarding than microeconomic reform. Tight macroeconomic policies cause short-term costs (economic growth) but also generate both short-term and medium-term benefits (increasing real incomes, especially among the poor, and greater economic stability). By contrast, microeconomic reforms cause a fair amount of short-term political costs and consume political capital (antagonizing well-organised, entrenched interests, typically forcing the government to compensate these groups in other ways), while the economic and political dividends are generally only reaped several years down the line (higher medium-term growth). From an electoral point of view, this is not particularly attractive. Finally, the political capital a government has to spend to adjust macroeconomic policy is far less than what it needs to spend to get structural reforms approved by congress due to its greater degree of control over macroeconomic policy instruments.
Critics will argue that the Lula administration simply got lucky, benefitting from a very favourable global backdrop. But this is a little ungenerous. Lula I/ II did raise and maintain large primary surpluses even at a time (after 2004-05) when lower surpluses would not have undermined debt sustainability. The administration also upheld the de facto autonomy of the central bank against at times harsh criticism of its tight monetary policy. The political calculus underpinning these decisions was straightforward and did pay off, leading Lula to be re-elected in 2006. The president’s approval ratings have surged since the onset of the crisis and were the president allowed to run for a third term, he would probably win hands-down.
The Lula administration’s key strategic insight was that lowering inflation and increasing economic stability, albeit at the expense of lower short-term economic growth, can be politically and electorally rewarding, as it raises the real incomes of the poor and satisfies the demands of the urban middle class for an end to near-permanent economic instability. What in 2003 may have looked like an emergency response to contain the financial crisis and avert a sovereign default has not only transmuted into a long-term policy; it has actually become the cornerstone of Brazilian economic policy and the main reason why Brazil is weathering the global crisis relatively unscathed. Is there any reason why this formula could not become a winning formula for political leaders in the currently poorly managed Latin American countries?