Stanford University

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NEWS RELEASE

10/13/99

Kathleen O'Toole, News Service (650) 725-1939; e-mail: kathleen.otoole@stanford.edu

When economic success sows the seeds of complacency

Economists who argue for a "big bang" approach to reform of government-managed economies would do well to heed Gustavo Franco's cautionary tale of his fall from grace in Brazil.

The governor of Brazil's central bank from August 1997 to last January, Franco was one of the leading architects of Brazil's 1994 "Real Plan" that successfully conquered hyperinflation in that country and staved off contagion from the Asian financial crisis, only to succumb to the temptations of its own success. A Harvard-trained economist, Franco was a visiting scholar the week of Oct. 11 at Stanford's Center for Research on Economic Development and Policy Reform, where he gave an insider's analysis of Brazil's recent reform history. Center Director Anne Krueger, who authored some of the studies that guided Franco's policy decisions, wanted to give scholars a chance to hear his firsthand account.

In hindsight, Franco did not advocate going slower with liberalization. He instead pointed to the political problems that economic reformers must take into account if they want to sustain reform beyond an initial success period.

"We had to find ways to prevent the politicians from declaring victory on inflation. When the results are good, economists lose control of the process," he said.

Beneficiaries of the old Brazilian economic system were hurt by the reforms but retained their political connections, he said, while "the new Brazil" of successful entrepreneurs and a growing middle class had yet to develop its political clout. The result was a decision by President Fernando Cardoso, following his October 1998 reelection, to devalue the Brazilian currency 13 days into his second term in January. If short-term benefits emerge from that strategy in the next year, Franco said, the future of Brazil could be a return to its old ways of protecting the powerful. The current government's inflation target of 8 to 10 percent, he added, is like "giving a drink to a country that is a recovering alcoholic."

The Real Plan began in July 1994 following seven years of inflation at rates of 30 percent or more per month. Hyperinflation, Franco said, was really a tax on the poor by the rich. Brazilian industries were protected from competition by high tariffs and given other subsidies, while inflation wiped out any wage increases for workers or social programs for the poor. This import substitution plan, he said, eventually destroyed itself, creating a crisis. To sustain the plan would have required tax rates of 50 percent of the country's gross national product.

After several failed price control plans, Cardoso, a former senator, was chosen finance minister, and the reformers he worked with saw the crisis as a window of opportunity to make five changes:

c A constitutional amendment was adopted that allowed the treasury to disregard the federal budget, thereby shrinking expenditures.

c A new unit of monetary accounting based on the real's international market value began four months before the new real became the official Brazilian currency.

c Banco Central do Brasil kept a tight reign on money supply.

c A floating exchange rate was adopted resulting in a rising value for the real for the first time in Brazil's history.

c Tariffs and other trade barriers were reduced across the board, introducing foreign competition and changing the way the prices were set in Brazil.

"Our ambition was zero inflation," he said, conceding that meant inflation and budget deficits not of zero but at the international average for industrialized countries. The problem, he said, was "making stabilization successful to the public but precarious to the politicians so they would be forced to deliver on their promises."

Stabilization brought the equivalent of a tax rebate of 3 percent of gross domestic product, he said, and lifted 7 million people above the poverty line. They voted for Cardoso, allowing him to win his first presidential election without a runoff.

The reformers moved onto privatization of state petroleum, steel and telecommunication industries. Labor productivity rose to 7.5 percent annually and foreign direct investment returned to pre-1993 levels. The public deficit was brought down but only to 5.9 percent by 1997, while the reformers had hoped for 3 percent, he said.

"The new Brazil had to fight the old one, which was heavily dependent on government and highly overrepresented in our industrial federations," Franco said.

The reforms helped stave off contagion from the 1997 Asian crisis, and international markets reacted so flamboyantly, Franco said, "that it produced something we feared complacency."

The Russian debt crisis was not so easy to fight, he said. "The problem was not reserves but [international] credibility. We had to go to the International Monetary Fund not to borrow dollars but to borrow credibility for our fiscal policy."

Industrial federations staged a protest of the central bank's interest rates last December, he said. "At this point, I thought it was time to increase interest rates to show we are going to keep with the same program. When I started to talk about that with the finance minister, I found things had changed. It became clear the president sympathized with the high interest rate complaints."

Franco offered his resignation, and the interest rates were lowered in January. At its worst, Brazilian currency devalued 74 percent on international markets and is now down 20 percent. Inflation has not proved as bad as it would have been before the reforms, Franco said, but wholesale prices are up 25 percent, suggesting 8 percent consumer rates do not yet fully reflect the inflationary pressure. The devaluation was a "fiscal disaster" for the government's deficit now at 13 percent of gross domestic product because much of its debt is dollar-denominated. Privatization is "entirely paralyzed," he said, because "the executive has lost the energy to pursue it" and the congress is talking about increasing taxes.

Asked to explain Cardoso's change in policy direction, Franco suggested the president represents the old Brazilian thinking. "He had the freedom to decide the second term in ways he didn't during the urgencies of the first one."

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By Kathleen O'Toole


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