The Dismal Science

Don’t Blame It on Rio … or Brasilia Either

The real is caught in a confidence trap.

Back in the 1980s, a friend sent me a postcard showing the famous statue of Jesus that overlooks Rio de Janeiro. Underneath the outstretched arms he had written a caption, “The debt is this big, and only God can repay it.” He was wrong: Brazil eventually worked its way out of the debt crisis and even became a favorite of foreign investors. As late as last summer, things still seemed to be going pretty well. And then the bottom fell out.

The economic history of Brazil is one of punctured enthusiasms–of brief episodes of hope followed by bitter disappointment. From the Amazonian rubber boom to the “Brazilian miracle” of the 1960s, the country has repeatedly seemed on the verge of an economic takeoff, only to slide back again into stagnation. Or as an old local joke has it, Brazil is the country of the future–and always will be.

But what has happened to Brazil over the last six months is perhaps the saddest story of all, because this time the punishment seems so unjustified. Back in September, when the backwash from Russia’s crisis forced Brazil to raise interest rates to almost 50 percent, one Brazilian lamented the situation: “Brazil has never had such a responsible government; the environment for business has never been so good; why is this happening to us?” Good question.

For the fact is that this time Brazil has tried very hard to play by the rules. Five years ago it introduced a new currency, the real, and promised to avoid the inflationary excesses of the past. Thus far it has delivered, with prices basically stable over the past year. Like other Latin America countries, Brazil also moved to free up its markets, privatizing inefficient companies, eliminating import quotas, lowering tariffs, and so on. While the process of reform has by no means been completed, the progress is real and substantial.

Then came Russia. What does Brazil have to do with Russia? Well, to a certain extent both were attracting money from the same people–specifically, hedge funds that were borrowing in dollars or yen and investing in higher-interest real or ruble bonds. When these funds lost money in Russia, some lenders became nervous and demanded their money back–which meant the funds had to sell off assets, which meant pulling money out of Brazil. But the main reason for “contagion” from Russia to Brazil was psychological: Seeing Russia default on its debt raised fears that Brazil, which also has large budget deficits, might be risky too. And so capital began fleeing the country. Initially Brazil tried to support the value of the real by selling dollars at the official exchange rate; but as its reserves of dollars declined it supplemented this strategy by raising interest rates to punitive levels in order to persuade people to keep their money in Brazil. Of course, these high interest rates also made a recession inevitable.

Now you might say that this only shows that countries should not run big budget deficits, that Brazil needed to get its government accounts under control to restore market confidence. And that has indeed been the thrust of the government’s policy, agreed upon with the International Monetary Fund. But there is something a bit funny about Brazil’s deficit, if you look at it at all closely. You see, Brazil is actually running a substantial “primary surplus”–that is, if you do not count the interest on outstanding debt, tax receipts are larger than spending. The primary surplus would be even larger than it is if the economy were not depressed, depressing tax receipts too.

S o the problem must be all that debt Brazil ran up in years past, right? Well, not exactly: It turns out that Brazil isn’t particularly deep in debt, by the usual measures. The government debt is less than half the annual GDP, no worse than the ratio for the United States and better than that of most European countries. What makes Brazil’s deficit so large is not the size of its debt but the very high interest rates it must pay on that debt–interest rates that are high because of a lack of investor confidence. And why do investors lack confidence? Because of those big deficits.

In case you somehow missed the absurdity of the situation, let me say it again: Investors lack confidence in Brazil because it has a large budget deficit, which is the result of high interest rates and a depressed economy, which are the result of investors’ lack of confidence. It’s completely circular. If markets were willing to give the country the benefit of the doubt–if, say, they were willing to hold Brazilian debt at a real interest rate only twice as high as that on U.S. bonds–Brazil’s budget deficit would not look scary at all.

So what’s the answer? Conventional wisdom, embodied in the IMF program that Brazil embarked on last fall, was that the way to break the vicious circle was for Brazil to demonstrate its resolve. And the way to do that was to make that primary surplus even larger and defend the value of the currency at all costs–which meant keeping interest rates high. This was supposed to convince the market that all was well, so eventually interest rates could come down. The trouble was that all that austerity was a hard sell politically–especially because the economy was going into a nasty recession thanks to those high interest rates. I don’t think you can blame Brazilian politicians: How well would our own Congress perform if told that taxes must be raised and spending slashed in the midst of a recession, with no clear reward except a possible reduction in speculative pressure, maybe, sometime in the future?

What were the alternatives? Some people–notably Harvard’s Jeffrey Sachs–said Brazil should simply let the real fall without raising interest rates, maybe even cutting them. Others–such as me–worried this would lead to such a massive devaluation that inflation would surge, and argued (in the wilderness) for temporary controls on capital flight.

Which brings us to the story of the latest crisis. The IMF program fell apart, predictably, though earlier than most people expected. Still, on the Friday in January when the real was floated things didn’t look too bad. The currency didn’t fall as much as some feared, and the stock market soared. It looked, in other words, as if Jeff Sachs had been right. Then, over the weekend, Washington officials convinced Brazil to raise interest rates. When the interest rate increase was announced, panic set in and the currency plunged. Instead of helping, in other words, the interest rate increase apparently simply reinforced the vicious circle.

Maybe it is still possible to push the reset button–to rewind the tape to mid-January and recapture that initial optimism. After firing two central bank heads in close succession, Brazil appointed an aide to George Soros–an interesting move, particularly given the market action over the preceding couple of days. (For more on the recent turmoil, click.) And perhaps the new man can somehow say the magic words, find the formula that will turn self-fulfilling pessimism into self-fulfilling optimism. But win or lose, the story is, let us say, not exactly a wonderful advertisement for either the competence of the IMF or the virtues of the New World Order.