Brazil’s Monetary Policy
Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” is well-understood in the monetary policy literature. It is equally true, however that the institutional arrangements and external circumstances surrounding monetary policy are equally important in generating positive or negative outcomes. The history of Brazilian monetary policy culminating in the hyperinflation of the late 1980s and early 1990s shows clearly the truth of this assertion.
The initial spark for hyperinflation was the existence of large fiscal deficits, which required central bank financing. Cardoso notes that “For a shaky democratic gov’t or military dictatorship of questionable legitimacy, doling out money was the obvious way to stay in power”, pointing to the modern era of runaway inflation that started in the 1950s under Juscelino Kubitschek. By the 1970s, in particular, Brazil was running large fiscal deficits.
Of course, large fiscal deficits aren’t necessarily inflationary if the central bank is independent. This was sadly not the case in Brazil. The central bank had little choice about expanding money during this period given the rules and procedures under which monetary policy was conducted. Meltzer notes similarities between the Italian experience of the 1970s and Brazil in the 1980s & 1990s. He writes, “The Italian government ran large budget deficits and issued debt finance. The Bank of Italy was responsible for purchasing all the bonds not sold in the market at a given rate of interest. The rate of interest was not allowed to clear the bond market, so the Bank of Italy issued base money to purchase the bonds.” Similarly, in Brazil, when inflation rose, the market put securities to the central bank, which issued base money to finance them. Nominal and real rates in the market were not high enough to ensure private participation.
Politicians were not the only ones benefiting from inflation. As Cardoso observes, Brazilian banks were the intermediaries for many bills, such as utility bills. They received payment for utility bills but waited three days before sending the money on to the utility companies. In a hyperinflationary environment, this practice of “floating” gave them an easy 8% profit in real terms. An estimated 25% of Brazilian bank profits came from “floating”.
Not everyone agreed with this monetary & fiscal explanation for Brazilian hyperinflation. Cardoso reminds us that with Brazil inflation reaching 2,500 percent in 1993, many were resigned to hyperinflation. “Attributing it to inherent structural issues within our economy, they simply threw up their hands in defeat”, he wrote. Slightly more subtle was the inertial argument of inflation, outlined by Kiguel and Liviatan. They asserted that the Brazilian and Argentine hyperinflations “were the final stage of a long process of high and increasing rates of inflation, in which a final explosion was all but unavoidable.”
There are shades of truth in the Kiguel and Liviatan argument. Certain structural elements had served to reinforce inflationary expectations for economic actors. The practice of indexation was an attempt to outrun inflation by including a component to offset inflation. This, however, only served to entrench inflationary expectations and formalize those expectations into economic life. As Cardoso says, “Inflation was built into virtually every contract in Brazil with a monetary value: rent, taxes, bank loans, utility rates etc… Indexation became almost as important a cause of inflation in Brazil as the original sin of budget deficits.” Due to indexation, “the economy became a captive of its own inflation-mitigation technology.” (Kiguel and Liviatan)
The entrenched nature of high inflation also stemmed from the incredible and desultory anti-inflationary policies pursued by various governments. Jose Sarney’s Cruzado Plan relied on price and wage controls with no adjustment on the fiscal side. Follow-up stabilization plans – the Bresser Plan, Summer Plan, and so forth - were essentially the same. (K&L) In 1988, Sarney’s plan to introduce a new currency failed, and inflation soared to 1,038 percent. Brazil went through three different currencies in five years. As each currency lost value, the government had to stop payment on its foreign debt. (Cardoso)
The government’s lack of credibility was clear when inflation probably accelerated in anticipation of a new income-based stabilization plan by the Collor de Melo administration (K&L). Indeed, the Collor plan, while superficially ambitious, did little to “frontally [attack] the structural features that gave rise to an inflationary economy, namely addressing public debt, reducing the size of the public sector and institutional reforms to control the money creation process.” (K&L) Furthermore, some of the elements designed to give the appearance of tackling those structural features merely served to weaken the real side of the economy. For example, the government instituted a mandatory freeze of 70% of financial assets for 18 months. While depositors lost access to money during the freeze, the funds were supposed to earn indexation plus 6% per annum. Most public financial assets were domestic government debt, so the purpose of freeze was to postpone payment on the service of domestic debt and improve the fiscal balance. (K&L) Not only was this merely deferring the problem of government deficits, it heightened uncertainty in Brazilian financial markets. Furthermore, when this drastic reduction in liquidity started to exert recessionary pressure, the government partially reversed some of its policies. Needless to say, the Collor Plan didn’t work. This led to Collor II in Jan 1991. Some attempts were made to deepen fiscal adjustment, but these were still accompanied by price and wage control and increased regulation of financial markets. (K&L) We thus see that, rather being inevitable, hyperinflation was “the combination of high inflation and induced nominal instability, caused by unsound stabilization strategies, [creating] the conditions for inflation to explode.”