In order to be able to reduce interest rates, the Official Gazette must not belie the recent official discourse of fiscal adjustment.
The reactions of economic policy in Brazil to the big crisis of 2008 are considered to have been successful. Although Brazil emerged relatively unscathed from the most critical period of the crisis, quickly resuming growth, a careful analysis is needed of what effectively happened during that period in order to improve the policies that should be adopted in light of the new stage of the crisis that we are currently facing.
In the past, when capital fled from the country, economic policy managers were forced to raise interest rates to prevent an excessive devaluation of the exchange rate that could lead to higher inflation and jeopardize growth, as well as implement austerity measures in the fiscal area so as to eliminate all doubts regarding the country’s solvency. In 2008, for the first time, it was possible to respond to the international crisis that sharply reduced credit flows to the Brazilian economy with countercyclical measures. Interest rates fell, public expenditures rose, and the economy was supplied with plentiful credit granted by state-owned banks.
Economic theory and international empirical experience teach us that, in stabilization policy management, it is better to use monetary rather than fiscal policy because the former acts much faster and in a homogenous fashion, affecting all economic agents. Fiscal expansion should only be used when monetary expansion has reached its limits, that is, when nominal interest rates cannot be reduced further.
Comparing Brazil’s responses to the 2008 crisis with those of other countries, the difference that stands out is that the reduction of the Selic rate was halted at an extremely high level – 8.75% – while fiscal and para-fiscal (subsidized loans from state-owned banks) policy was already strongly expansionary. Brazil’s performance would have been even better had the economic policy mix involved less fiscal and more monetary policy loosening. The same argument applies even more as from 2010, when the expansion of fiscal and para-fiscal policy was maintained, despite the economy’s robust growth (7.5%), and the Central Bank had already begun to raise the Selic rate. Such a mistaken policy combination was largely due to the government’s electoral campaign concerns.
In order not to repeat the errors of the past, if the resurgence of the crisis were to threaten the Brazilian economy, what should the macroeconomic policy response be? It is essential to prepare the way for a substantial decline in the Selic rate, currently at 12.5%, without putting the control of inflation at risk. And how can this be achieved? Imposing a greater short and long-term fiscal and para-fiscal rigor.
Unfortunately the government has already adopted measures that go in the opposite direction to this recipe. The one with the greatest impact is the increase in the minimum wage (MW), due next January, of probably around 15%. Besides representing, in itself, a sharp increase in social security expenditures, an increase of this size will act as a beacon for important collective bargaining and wage negotiations that will take place during the second semester. The inflationary impact of MW and other salary raises will be decisive in determining the room available to the CB to loosen monetary policy. Most of the Greater Brazil plan (http://www.brasilmaior.mdic.gov.br/) measures that involve tax breaks, greater public spending, or disguised protectionism will also have an inflationary impact. In other words, many of the short-term measures that have already been adopted by the government will make it more difficult to reduce interest rates. It is important to curb fiscal expansion in order not to aggravate the situation. It is indeed true that the official discourse changed all of a sudden, and has begun to emphasize the need to limit increases in public spending. One hopes that the Official Gazette will not belie the official discourse.
It is also fundamental to implement measures that can guarantee the public sector’s long-term solvency, involving long-mapped initiatives such as public and private sector social security reform. Moreover, finally getting the Lower House to vote on the bill that limits real increases in federal public employee salaries is another measure that would help assure that the debt/GDP ratio does not, in the long term, reach the levels that is currently weighing on the economies of various European countries. The time to implement such measures is now, when the sacrifices required are not as great as those that are overburdening the Greeks.
It is argued that a fiscal adjustment would attract even more capital and contribute to an even greater appreciation of the BRL. The argument was already shaky even before the aggravation of the crisis. Now, when the risk is one of capital flight and the devaluation of the BRL, it has been rendered meaningless. Furthermore, in the most likely scenario of a sharp deceleration of the world economy with zero interest rates in the USA for two more years, Brazil runs the risk of being inundated by large amounts of capital inflows to purchase government bonds while receiving few directed towards financing productive investment. In this situation, lowering interest rates on the one hand and, on the other, proffering unequivocal signs of the public sector’s solvency, would constitute fundamental steps towards enabling the Brazilian economy to absorb the foreign savings needed for productive investment and economic growth.
With 12-month inflation already well above the inflation-target-band ceiling (6.5%) and many obstacles standing in the way of its decline during the second semester, it would be over hasty to defend the Selic’s immediate and substantial reduction. But it is crucial to create conditions that enable the CB to do so when necessary without jeopardizing the control of inflation.