Failure as a Precondition for Success? ‟s Battle with

Lauren Gramza Mathematical Methods in the Social Sciences Northwestern University Advisor: Prof. Stephen Nelson June 6, 2011

ABSTRACT

For decades, Brazil and many other Latin American countries battled with chronically high inflation. This thesis analyzes the Brazilian context surrounding inflation as well as stabilization and reform attempts beginning after the transition to democracy in 1985 through the successful , implemented in 1994. During this period, a number of stabilization programs were planned and unsuccessfully executed. It is my contention that these failures mark instances of change in the Brazilian context that had an impact on future reform efforts and the eventual success of the Plano Real. This thesis argues that the accretion of small pieces of reform over time, through processes such as political learning, alteration of the status quo among key actors in society, and changes in the initial conditions preceding reform programs, contributes significantly to the probability of successfully stabilizing inflation (and consequently being able to pursue deeper structural reforms once stability is achieved). I elaborate on the Brazilian experience with stabilization and reform programs to demonstrate qualitatively what accretion of reform looks like. I then test my hypothesis that accretion of reform contributes substantially to successful inflation stabilization across a wider sample of Latin American countries. The results demonstrate that this theory does indeed apply outside of the Brazilian context. Stabilization and reform program failures may be demoralizing at the time, but they should also be viewed as a set-up for future success by virtue of their contribution to the incremental accretion of reform.

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TABLE OF CONTENTS

List of Tables …………...………………………………………………………………….…….. 4

Introduction ……………………………………………………………………………………… 5

Literature Review ……………………………………………………………………………..... 12

Theory of Reform Success …………………………………………………………………..…. 24

A Brazilian Case Study ………………………………………………………………………… 30

A Quantitative Approach .….…………………………………………………………...……… 60

Concluding Remarks …………………………………………………………………………... 72

Bibliography……………………………………………………………………………….…… 77

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LIST OF TABLES

1.1 Monthly Inflation in Brazil …………………………………………………………………..7

4.1 Plano Cruzado Measures ……………………………………………………………………35 4.2 Plano Verão Measures ………………………………………………………………………42 4.3 Measures ……………………………………………………………………...45 4.4 Brazil Average Import Tariffs (percent) …………………………………………………….48 4.5 The Plano Real‟s Fiscal Adjustment Measures ……………………………………………..55 4.6 A Chronology of Key Economic Reforms and Events, 1994-99 …………………………....59

5.1 Sustained Fall Observations …………………………………………………………………62 5.2 Survival Analysis – Cox Model ……………………………………………………………..66 5.3 Logit Estimations ……………………………………………………………………………67 5.4 Logit Estimations with Country Fixed Effects ……………………………………………...67 5.5 Index Statistics ……………………………………………………………………………....68 5.6 Marginal Effects after Logit of Index Scores at Min and Max ………………….………..…69 5.7 Survival Analysis Incl. GDP Growth, Fractionalization Effects …………………………... 69 5.8 Logit Estimations Incl. GDP Growth, Fractionalization Effects …………………………... 70 5.9 Logit Estimations with Country Fixed Effects Incl. GDP Growth, Fractionalization Effects…………………………………………………………………………………………... 71 5.10 Marginal Effects after Logit (Incl. GDP Growth, Fractionalization Effects) of Index Scores at Min and Max Levels……………………………………………………………………..…... 71

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CHAPTER 1 INTRODUCTION

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It is October 3, 1994, and it is election day in Brazil. For the first time in decades, you, a citizen of this maturing democracy, have some faith that the R$1 (1 , the newest of six introduced for differing durations over the past decade) you hold in your pocket today will still be able to buy the milk your family requires tomorrow, a novel thought for

Brazilians. After decades of chronic high inflation and exceptionally high 2000% + inflation over the past year, you have faith that the man just elected president has put a stop to the vicious cycle of inflation endemic in the Brazilian economy. Fernando Henrique Cardoso introduced the Plano

Real just seven months prior to this election as the Minister of Finance under President Itamar

Franco, and just three months ago that R$1 in your pocket was introduced as the new , the last phase of this elaborate plan to finally put an end to the country‟s battle with chronic high inflation. After numerous failed stabilization attempts (six since 1986 with widely vacillating monthly inflation rates throughout, as can be seen in Table 1.1 below, which shows the monthly inflation rate to the point when Cardoso assumed the position of finance minister), the Plano

Real and Fernando Henrique Cardoso succeeded in doing what scores of others had strived to achieve: providing a measure of economic stability and reform.

But why did the Plano Real succeed? Many of the elements contained in this plan were also addressed in prior stabilization attempts. While the situation in Brazil was dire by developed-world standards in 1994, it was par for the course in Brazil‟s since re-democratization in 1985 and before. Countless factors can contribute to policy success or failure, and understanding which factors played the most instrumental role in the success of the

Plano Real is my primary aim in this study, which holds the promise of illuminating conditions ripe for stabilization and reform elsewhere. Possible factors to explain success in inflation

6 stabilization may be increased democratic inclusiveness and government responsiveness, a paradigm shift in Brazilian economic thought, a breakdown of social deadlock that was preventing reforms from succeeding, increased credibility of Cardoso as opposed to previous political actors who failed in stabilization attempts; all of these factors could contribute to the success of the Plano Real in 1994. My focus is on what made the situation in 1994 distinct from previous periods and what allowed Fernando Henrique Cardoso to overcome one of Brazil‟s most fundamental barriers to further development and stability: inflation.

TABLE 1.1 Monthly Inflation in Brazil 1 1986 1987 1988 1989 1990 1991 1992 1993 January 18.0 12 19 36 72 20 27 29 February 15.0 14 18 12 72 21 25 26 March -0.1 15 18 4 81 7 21 28 April -0.6 20 20 5 11 9 18 28 May 0.3 28 19 13 9 6 22 32 June 0.5 26 21 27 9 10 21 31 July 0.6 9 21 38 13 13 22 32 August 1.3 4 23 36 13 15 25 September 1.1 8 26 39 12 16 27 October 1.4 11 28 40 14 26 25 November 2.5 14 28 44 17 26 24 December 7.6 16 29 49 16 22 24

An approach to the topic of the successes and failures of Brazilian stabilization and reform is met immediately by a number of complicating factors. Brazil is a complex federative republic, as well as a multi-party presidential system. These attributes present difficulties for implementing and sustaining successful reform and stabilization, because (simply put) the federative system creates a power struggle between the central government and the states, the multi-party system makes it difficult to achieve a consensus on difficult policy issues, and the

1 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 192.

7 presidential system is more conducive toward executive/legislative tension than cooperation.

While the citizens of many Western democracies know life under no other political system,

Brazil‟s relatively new (b. 1985) and fragile democracy means that this fledgling political system required a great deal of nurturing, and the polarization of politics around the issue of economic stabilization and reform certainly was not conducive to its maturation.

Against this political backdrop, one must also consider the economic legacy left in place by over two decades of military-authoritarian regime (1964-1985). By the time the military regime relinquished power to civilian authorities (under a transition designed by the military regime itself), Brazil‟s economy was in shambles. Inflation reached 226% for the year in 1985

(from 102% in 1981)2. The GDP growth overseen by the military in the 1960s and 70s reversed itself in the 1980s, and Brazil posted serious GDP (per capita) contractions in 1981 (-7%), 1982

(-2%), and 1983 (-6%)3. As a result of Brazil‟s earlier spectacular growth (the average yearly growth rate for the 1947-62 period was over 6 percent4 and the average annual real growth rate of GDP soared to a remarkable 11.3 percent over the 1968-74 period5) and the external funding which made such growth possible, the new democratic government that came to power in 1985 was immediately confronted with a soaring stock of external debt, which reached over $100 billion that same year. Thus, during its transition to democracy, Brazil was also forced to confront the legacies of the military‟s policies of import substitution industrialization and debt- led growth.

2World Bank. “The World Bank Open Data – Brazil.” 1980-2000. 3 Ibid. 4 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 63. 5 Ibid. Page 75.

8 Under these political and economic circumstances in 1985, José Sarney became the first civilian president in 21 years. This was not an easy transition to democracy, since Sarney was never actually elected as President (he was elected instead as Vice President under Tancredo

Neves) but assumed the job when president-elect Neves became suddenly ill prior to inauguration and passed away soon thereafter. A hallmark of Sarney‟s administration was the

Plano Cruzado (1986), his first attempt to tame Brazil‟s increasingly erratic inflation. After a short period of success, the plan fell apart and inflation returned with a vengeance. This story has oft been repeated in Brazil with plans such as the Plano Bresser (1987), the Plano Verão (1989), and the Plano Collor (1990). After each plan‟s failure, inflation rebounded to even higher levels than before the plan was administered.

From the mid-1980s through 1994, numerous presidents and finance ministers implemented economic stabilization and reform programs in an effort to stabilize inflation and return Brazil to a path of sustainable growth. In the era of the “New Republic” – the post-military dictatorship era starting in 1985 - seven economic plans fell by the wayside, leading to ever- higher inflation and increasing economic turmoil. Focus on the failures of these plans fails to recognize the elements of reform that had a lasting impact. It is my premise that the elements of these plans that persisted as the rest of the simultaneously implemented stabilization measures fell by the wayside created an important base of reform off of which future efforts could build.

While they ultimately failed by most evaluations, plans such as the Plano Collor (1990) combined stabilization measures with a set of reforms focused on removing restrictions to free enterprise and trade, increasing competition, privatizing public enterprises (the National

Privatization Plan, also known as the PND), and boosting productivity. With the failure of the

9 Plano Collor’s stabilization measures came the return of inflation, but many of the advances in reform stuck, such as the privatization and trade liberalization elements.

As evidenced by the Abiad/IMF dataset “A New Database of Financial Reforms,” Brazil only saw increases in its score for financial reform after 1988, and in 1989 the country reached a level heretofore unattained (as far back as 1973, the extent of the Abiad dataset).6 Morley,

Machado, and Pettinato construct indexes of structural reform in 17 Latin American countries for the 1970-1995 period in five areas: trade reform, financial liberalization, tax reform, liberalization of external capital transactions, and privatization. For the majority of their indexes

(to be discussed and utilized in greater detail later in this paper), Brazil sees a marked improvement in 1989/1990 and only improves from that point forward.7 While a number of factors can go into explaining why the Plano Real finally tamed Brazilian inflation in 1994, most important (and perhaps least considered) among these are the effects that previous failed attempts had on the Brazilian system.

Trade liberalization undertaken under the Plano Collor (the average external tariff in the

1990s was 32.2%, and was scheduled to be cut in half by 1994 to 14.2%8) changed the power relations within Brazilian society. Trade liberalization was a dramatic break with the protectionist past, and such a shift in policy could not help but have a significant effect on the

Brazilian economy and the actors of which it consists. While under a regime of trade protection, domestic exporters were at a disadvantage to non-exporters. The Plano Collor’s industrial and foreign trade policies aimed to modernize the Brazilian economy and increase Brazilian

6 Abiad, A., E. Detragiache, et al. (2010). "A new database of financial reforms." IMF Staff Papers 57(2): 281(222). 7 Morley, S. A., R. Machado, et al. (1999). Indexes of Structural Reform in Latin America, ECLAC Economic Development Divison. 8 Fritsch, W. and G. H. B. Franco (1991). Brazil and the World Economy in the 1990s: Emerging Trade and Investment Issues. , Departamento de Economia - PUC-RJ. Page 6.

10 competitiveness by encouraging both local innovation and the entrance of foreign firms. Once trade was opened in the early 1990s, exporters gained strength at the expense of formerly protected sectors, and this shifted the balance of support in favor of further reform (exporters are traditionally pro- economic reform and liberalization, while domestic protected sectors push against reform attempts that will undoubtedly alter the status quo from which they benefit). By privatizing public enterprises and encouraging increased competition, the Plano Collor also marked the beginning of a long journey in Brazil towards increased efficiency and ability to compete in the global marketplace once effective inflation stabilization could make such relationships with the global system more feasible. These measures had the effect of creating more groups that had a greater deal at stake if future stabilization efforts were to fail. While part of what contributed to the ultimate failure of the Plano Collor was the mobilization of segments of society that would be most directly hurt by the plan, the elements of the Plano Collor that remained in place had the effect of changing the balance in society to create a more favorable base for the successful Plano Real. The accretion of these smaller reforms that stuck while greater efforts at inflation stabilization failed is what is crucial in understanding the success of inflation stabilization and further reform embodied in the Plano Real and subsequent efforts. In the case of Brazilian inflation stabilization, failed programs had lessons to offer and in many ways paved the way to later success.

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CHAPTER 2 REVIEW OF THE LITERATURE

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There exists a plethora of trends analyzed in the literature on post-authoritarian Brazilian economics, politics, and society that lends itself to describing the challenges faced in efforts to stabilize and reform the financial and economic systems. There are also two distinct approaches to analyzing these trends in Brazil, qualitative and quantitative, both of which are indispensible in this piece of work. It is impractical to attempt to operationalize each and every theory explaining some aspect of Brazil‟s evolution after its transition to democracy quantitatively, but it is enlightening to use some promising existing theories to bolster my own thesis regarding the utmost importance of the accretion of reform for the success of the Plano Real in stabilizing the

Brazilian economic system. I will do this through a case study analysis of Brazil with regard to these theories. Highlighted in relation to my analysis of Brazil are: theories regarding a „war of attrition‟ in society making stabilization and reform difficult; structural factors of political life such as polarization and fragmentation which can stifle reform efforts; the strength of labor; confidence-building in reform efforts and demobilizing beneficiaries of the status quo; the impact of evolving interactions between such actors as the government, banks, and industry; the

“Nixon-in-China” hypothesis that successful policy initiatives are more likely to be implemented by an unlikely party; and, of course, the idea that structural reforms left an impact on the

Brazilian system even after accompanying stabilization measures failed.

Alessandro Prati and A. Javier Hamann have compiled a convenient check-list of factors, theorized in great depth by many of the scholars I cite below, contributing to the success or failure of a stabilization plan9:

 Past failures reduce the chances of success;

9 Hamann, A. J. and A. Prati (June 2003). "Beating Inflation: The Importance of Luck, Timing, and Political Institutions." Finance and Development Vol. 40(2): 12-15.

13  Bad initial conditions may help (the “crisis hypothesis”);  Some good initial conditions may also be conducive to success (e.g. relatively high levels of international reserves);  -based stabilizations are more likely to succeed;  Countries with open financial sectors are better off ;  Countries with long-lived political institutions are more likely to succeed;  A government with a strong executive branch is more likely to succeed;  Democracies with majoritarian electoral rules tend to succeed;  New governments are less likely to fail;  Social cohesion makes success more likely, but, surprisingly, political cohesion does not;  A real appreciation of the exchange rate can derail stabilization programs;  International reserves play an important role.

I will now proceed by discussing many of the theories behind the factors enumerated above according to the natural division apparent in the Prati-Hamann listing between political economy and purely economic factors behind stabilization success and failure.

2.1 Political Economy Explanations

In contrast with an approach that takes a purely economic focus, or a purely political focus for that matter, political economy explanations highlight that these two realms go hand-in- hand in shaping the policy environment in which stabilization and reform attempts will take place. There are highly developed interrelationships among the political sphere, the economic sphere, and the social sphere, with each affecting all the others. Alesina and Drazen take this into account with their societal „war of attrition‟ model, Remmer puts focus on the changing power of labor, Treisman emphasizes the importance of demobilizing key segments of the population,

Armijo discusses how different actors in Brazilian society interacted and how their preferences changed given changing economic/political circumstances, and Cukierman, Tommasi, and

Velasco call attention to the importance of the figure promoting reform as well as his policy leanings. It is the elaboration of these political-economic theories to which I now turn.

14 Highly influential, and highly relevant to my own argument, is the theory of a „war of attrition‟ advanced by Alesina and Drazen.10 The substance of their argument is that economic stabilizations have important distributional implications and costs that different groups in society wish to push off onto other groups. In their own words, “the process leading to stabilization becomes a „war of attrition,‟ each group attempting to wait the others out and stabilization occurring only when one group concedes and bears a disproportionate share of the burden.”11 In essence, stabilizations are costly, and no group wants to be the first to capitulate, because that demonstration of weak position will negatively impact the groups‟ post-stabilization welfare (in relation to other societal groups; since chronically high inflation hurts nearly all segments of society, its stabilization is on net positive for all, but some groups may benefit comparatively more). Historically, inflation has tended to hurt the poor most of all, because they have no other recourse except to hold their money as it quickly loses value. While the middle and upper classes have comparatively widespread access to overseas accounts and domestic indexed accounts that serve to protect their money from the effects of inflation, the poor have fewer financial channels open to them and are thus left paying a hefty portion of the inflation tax. Thus, it is the poor who are most hurt by inflation, and it is also the poor who will most likely have to capitulate as inflation increases beyond some threshold since those in higher income brackets do not feel the effects of inflation as much and consequently can hold out longer in bargaining over the post- stabilization welfare distribution.

Alesina and Drazen rightly point out that delays in stabilization can be extremely costly in terms of future policy adjustment needs as well as in terms of the economic inefficiencies

10 Alesina, A. and A. Drazen (1991). "Why are Stabilizations Delayed?" The American Economic Review 81(5): 1170- 1188. 11 Ibid. Page 1170.

15 created because of instability prior to successful stabilization. According to the theory, political polarization is related positively to longer periods of instability (largely because there is very little middle ground on which to meet and bargaining is less likely between actors with very distinct, often contradictory views), and more institutional adaptation to the distortions created by instability (e.g. sophisticated indexation arrangements in the Brazilian financial system) will also contribute to delayed stabilization. Having lived with chronic high inflation for years, the

Brazilian financial system had a unique set of indexation mechanisms that allowed the economy to continue operating in the high inflation atmosphere. Such indexation systems included wage adjustment mechanisms that allowed wages to be adjusted upward as inflation increased, which then led firms to raise prices on the goods those wage-earners produced, which fuelled inflation ever higher. These were sophisticated systems that had the stated aim of protecting the workers‟ share of the distribution of income, but they were also a self-propagating mechanism for inflation.

In addition to political polarization and institutional adaptation, Alesina and Drazen also discuss the effects of election timing and credibility issues on the timing of stabilizations, but for the purposes of this study, a focus on the „war of attrition‟ component in itself is sufficient. The

Brazilian government had recently become more politically inclusive by virtue of transitioning to a democratic system, and it is little wonder that issues of meeting the wishes of voters became incredibly important for politicians.12 These voters could make demands on the government, and if politicians wanted to be re-elected, they would have to respond to such organized interests as labor, industry, and other actors that had been stifled under the military regime. What is of

12 Armijo, L. E., T. J. Biersteker, et al. (1994). "The Problems of Simultaneous Transitions." Journal of Democracy Volume 5(Number 4): 161-175. Page 162.

16 interest is how this problem of a „war of attrition‟ in society could persist through a number of economic stabilization plans but would finally be solved with the Plano Real.

As Karen Remmer asserts, “… the findings suggest that macroeconomic performance in contemporary Latin America reflects eminently political processes of policy formation shaped by partisanship, electoral competition, and union strength.”13 In her theory, labor strength in Latin

America is “assumed to yield negative results in terms of fiscal and monetary performance, macroeconomic stability, capital flows, and, over the long run, growth.”14 15 It is with this in mind that I examine the effects on Brazilian labor of the elements of stabilization and reform programs since the mid-1980s that were successful. Given the idea of a „war of attrition,‟ I assert that the changing relative strength of labor would contribute to successful reform in 1994 with the Plano Real.

Daniel Treisman approaches this idea from a more case-based perspective, focusing on the case studies of Argentina and Brazil. He highlights the importance of demobilizing key beneficiaries of inflationary policies as well as creating confidence in the durability of reforms.16

Treisman analyzes the successes of Brazil‟s Fernando Henrique Cardoso and Argentina‟s Carlos

Menem in stabilizing their respective countries‟ chronic inflation after years of failed attempts.

Contributing to both leaders‟ successes is the fact that “Both presidents split the labor movement, co-opting parts in order to isolate the rest. Both wooed business leaders with tariff protection or

13 Remmer, K. L. (2002). "The Politics of Economic Policy and Performance in Latin America." Journal of Public Policy 22(1): 29-59. Page 29. 14 Ibid. Page 39. 15 According to Remmer’s theory, as labor increases in strength, “labor movements are expected to undermine the capacity of governments to achieve their policy preferences both directly and indirectly, by pressuring for less restrictive fiscal policies and/or higher wages. Indeed, the mere threat of labor pressure may induce expectations of policy instability and failure, erode investor confidence, and thereby reduce performance (page 39).” 16 Treisman, D. (2004). "Stabilization Tactics in Latin America: Menem, Cardoso, and the Politics of Low Inflation." Comparative Politics 36(4): 399-419. Page 399.

17 privatization benefits and provided domestic banks with short-run aid while ultimately weakening them relative to foreign competitors.”17 Treisman identifies four main groups which benefited from inflationary spending and needed to be co-opted or weakened: public sector employees, politicians in parliament, state governors, and the business community. Cardoso successfully courted these groups and succeeded partially by learning from his predecessors‟ mistakes in disregarding or not taking seriously the interests of these groups in an instance of political learning. An anonymous reader pointed out that this political learning should be considered a form of accretion – one of political know-how in setting the stage for a successful reform effort.

In a related vein, Leslie Armijo discusses how different sectors of Brazilian society interact in a game theoretic manner. She analyzes the interactions between industry, the government (as two actors: the executive, and the legislature and states), labor, and banks

(representing financial capital). Armijo analyzes four games: (1) Industry v. Government, (2)

Labor v. Government, (3) Government (Executive) v. Government (Legislature and States), and

(4) Banks v. Government. She asserts that the first three games are best modeled as an iterated

“Prisoner‟s Dilemma,”18 whereby both sides find it mutually beneficial to cooperate and reach an agreement over stabilization. In the fourth game we find a game of “Deadlock,” meaning that the banks prefer to see the inflationary status quo rather than any agreement that leads to stabilization. This finding rests on an analysis of some unique aspects of the Brazilian financial system which actually allow it to profit from inflation, making it a huge detractor of stabilization

17 Ibid. Page 400.s 18 While the Nash equilibrium strategy to the classic Prisoner’s Dilemma is for each party to defect, when iteration is introduced each player has the chance to punish the other player for past defections. Thus, with an infinite time horizon, the iterated Prisoner’s Dilemma can result in a cooperative outcome that is both mutually beneficial and a better outcome than the classic Prisoner’s Dilemma result. One can read more about the iterated Prisoner’s Dilemma in Robert Alexrod’s The Evolution of Cooperation (New York: Basic Books, 1984).

18 measures. Armijo calls attention to the fact that “one study found that in 1987, the inflationary transfer to banks from the rest of Brazilian society via mechanisms like non-indexed deposits and the float totaled fully 4 percent of the gross domestic product.”19 She points out, however, that with the maturing of democracy in Brazil, labor has been given an increasing voice in the political realm and that there may be a shifting in the balance of power among the relevant actors. We will see evidence of this in my Brazilian case study with the increasing power of labor under the maturing democratic regime. These ideas, in addition to those espoused by

Treisman and Alesina and Drazen, factor into an analysis of the changing dynamics in Brazilian society and politics, and how these shifts may have made the success of the Plano Real possible when numerous other plans had failed.

In considering government as an actor in stabilization programs, it is interesting to consider the impact of its political orientation. The “Nixon-in-China” hypothesis, elaborated by

Cukierman and Tommasi, is intriguing to think about, along with its implications for reform efforts in Latin America. Briefly, Cukierman and Tommasi assert that substantial reform efforts

(like market-oriented reforms) are sometimes undertaken by unlikely parties. In applying their logic to market-oriented reforms, they argue that “politicians coming from the left of the spectrum, when faced with the fact that such policies were necessary, had a comparative advantage in convincing people of the long-run necessity of these changes, even if they hurt now.”20 Tommasi and Velasco apply this same logic to Latin America in particular and identify a number of instances where orthodox reforms were implemented by leftist parties, including in

Argentina under Menem, in Peru under Fujimori, and in Bolivia under Victor Paz Estenssoro. In

19 Armijo, L. E. (1996). "Inflation and Insouciance: The Peculiar Brazilian Game." Latin American Research Review 31(3): 7-46. Page 25. 20 Cukierman, A. and M. Tommasi (1998). "When Does It Take a Nixon to Go to China?" The American Economic Review 88(1): 180-197. Page 192.

19 essence, as Tommasi and Velasco write, “the statement „we have to undertake these tough adjustment measures today in order to improve our future‟ has more credibility when heard from the lips of a populist than from the lips of a „Chicago boy.‟”21 The proposal of painful orthodox reforms has more credibility in the eyes of much of the population when coming from someone more ideologically opposed to such measures, because they are more likely to be seen as truly necessary rather than just as a natural ideological tendency of the party proposing the reforms. In sum, a right-wing politician proposing orthodox reforms is par for the course, but a left-wing politician proposing the same measures causes the people to take notice and truly consider their necessity. It is enlightening to analyze Cardoso‟s rise to power in light of this theory, since he was a left-of-center candidate who achieved majority support in the 1994 presidential election despite some of his neoliberal economic policy prescriptions. A further analysis of Cardoso‟s political and economic stance will follow in my case study of Brazil.

2.2 Economic Explanations

As enlightening as the political-economic theories discussed above are for the timing of

Brazilian economic stabilization and reform, no review of the literature on this subject would be complete without paying due attention to the importance of the economic circumstances surrounding reform efforts. Prati and Hamann draw attention to economic explanations with many of their criteria (bad initial conditions may behoove reform, exchange-rate based stabilizations are more successful, international reserve levels matter, a real appreciation can hurt chances for success), as well as how their effects on the policy-making environment matter.

Veiga analyzes factors that contribute to stabilization failure and asserts that economic

21 Tommasi, M. and A. Velasco (1995). Where are We in the Political Economy of Reform? Economic Reform in Developing and Transitional Economies. Columbia University. Page 21.

20 conditions have primary explanatory force. Da Fonseca elaborates a theory about the openness of the financial sector and its impact on reform success. For their part, Da Fonseca, Zoninsen, and

Kiguel and Liviatan also stress the importance of structural economic reforms. Let me now turn to each of these theories in turn to elaborate on them in greater detail.

Francisco José Veiga summarizes the war of attrition argument by Alesina and Drazen:

“Ideological polarization, political fragmentation, lower costs of inflation, and greater dispersion of income across interest groups can delay fiscal stabilization.”22 Using a binary probit model over 34 stabilization attempts, Veiga identified these primary contributing factors to inflation stabilization plan failure: real exchange rate appreciation, lack of foreign reserves, and government budget deficits. However, in discussing a number of models, Veiga suggests that what fellow economist J.R. Lothian stated may hold true: “Actions that are optimal in a purely economic sense many not be optimal at all once political influence enters the picture.”23 My thesis, then, is an extension of sort of the models run by Veiga, accounting for some of the societal and political factors brought up in his study. Veiga‟s models demonstrate the importance of real exchange rate appreciation, lack of foreign reserves, and government budget deficits as the main causes behind inflation stabilization plan failure. By controlling for these variables in my countries of study, I will attempt to uncover the underlying political and societal causal factors. Budget deficit levels, and to a certain extent reserve levels, are chosen by the government, so understanding the dynamics behind these variables is key to understanding economic stabilization and reform successes and failures. Since individuals may not always act optimally in an economic sense because of the societal and political factors they take into

22 José Veiga, F. (1999). "What causes the failure of inflation stabilization plans?" Journal of International Money and Finance 18(2): 169-194. Page 191. 23 Lothian, J. R. (1991). "Political factors in international economics: an overview." Ibid. 10(Supplement 1): S4-S15. Page S6.

21 consideration, understanding how those factors affect which economic policy choices the people will support (and thus that the government can successfully implement) is invaluable insight when it comes to explaining what separates a successful reform effort and a failed reform effort ex ante.

A final piece of work, which serves as the inspiration for my thesis, is that of Manuel Da

Fonseca. In his “Brazil‟s Real Plan,” Da Fonseca speaks of the so-called abertura, or opening of the Brazilian economy, that took place in Brazil starting in 1990. The idea behind abertura was to introduce competition from foreign products in order to promote the modernization of Brazil‟s productive structure. Also introduced at the beginning of 1990 was a privatization plan under then-President Collor, aimed at reducing the intervention of the state in the process of resource allocation. Both of these efforts were largely begun under otherwise-unsuccessful attempts at economic stabilization during the Collor administration. In stating that “several structural changes that were initiated years before the start of the plan were decisive in bringing about a strong reduction of inflation,”24 Da Fonseca provides the intuition on which I will elaborate and which I will test empirically.

This idea attracts support from a number of sources. Jonas Zoninsein expresses that “the crucial element which has been missing in all recent unsuccessful attempts to control inflation is the redefinition of the institutional mechanisms that mobilize and channel the funds for supporting the accumulation of productive capital.”25 He asserts that, even as the Plano Collor contained trade liberalization and privatization components which aimed at such a redefinition of the role of the state in the economy, it failed to consider its “strategic influence on the path of

24 Fonseca, M. A. R. D. (1998). "Brazil's Real Plan." Journal of Latin American Studies 30(3): 619-639. Page 633. 25 Zoninsein, J. (1994). "Financial Reform, Control of Inflation, and State Intervention: Lessons from the Brazilian Experience." The Developing Economies 32(3): 331-349. Page 331.

22 growth and the structure of the productive sector.”26 While Zoninsein paints this as a failure on the part of the Plano Collor, it is my hypothesis that such incremental efforts at reform which stuck were key in the success of the Plano Real.

For their part, Miguel Kiguel and Nissan Liviatan acknowledge that “the programs [those in Peru – August 1990, in Brazil – March 1990, and in Argentina – July 1989] were announced as comprehensive efforts also aimed at changing the long-term prospects for growth, and for this purpose they included major structural reforms, mainly privatization of public sector enterprises and trade liberalization.”27 They even go so far as to say that, in Argentina in 1989/1990,

“success was achieved by combining a critical mass of reforms affected during the stabilization and by fixing the exchange rate.”28 This claim regarding a critical mass of reforms is what I wish to provide evidence for in the Brazilian case and across a wider Latin American sample with my theory of accretion of reform. This idea of accretion of reform has been alluded to, as evidenced above, but it is woefully under-theorized. It is my premise that this accretion is a crucial element of reform success that must be taken into account in understanding why a number of plan failures

(which, according to the Prati-Hamann list presented in the opening of this chapter, should hinder future success) can actually contribute to success through the changes they leave behind in society, the economy, and in policymakers. It is to this mechanism, describing how past stabilization and reform failures change the policymaking arena and enable future success, I turn to next.

26 Ibid. Page 347. 27 Kiguel, M. A. and N. Liviatan (1995). Stopping Three Big : Argentina, Brazil, and Peru. Reform, Recovery, and Growth: Latin American and the Middle East. R. Dornbusch and S. Edwards, University of Chicago Press: 369- 414. Page 391. 28 Ibid. Page 400.

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CHAPTER 3 THEORY OF REFORM SUCCESS

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My primary purpose in this thesis is to elaborate my theory of the accretion of reform and defend it through both a qualitative case study of Brazil and empirical testing of not only Brazil but also a wider sample of Latin American countries. This will allow me to demonstrate clearly the idea of what reform accretion looks like through the Brazilian example and to test whether this phenomenon holds across countries in the region. In setting up my analysis in this manner, it is beneficial to outline my theory of reform success in this section, continue on to demonstrate its application in Brazil, and then go into the quantitative methodology and data analysis sections.

It is key for me to define the causal mechanism that translates the accretion of previous efforts to the final resounding success of a large reform program like that begun under the Plano

Real in Brazil. As I see it, there are three possible channels through which the failures of past reform efforts (and the consequential effects they leave on society and policy-makers) contribute to future reform success: (1) contributing to political learning on the part of the policy-makers and society; (2) breaking the social deadlock of the “war of attrition” model; and, (3) altering the initial conditions for future reform efforts. I will discuss each of these, and the types of evidence one would seek to identify the activation of each of these channels, below.

I do not intend to dispute the fact that Brazil has seen a number of failures in reform since the mid-1980s. The Plano Cruzado, the Plano Collor and the rest largely failed in their mission of stabilizing the Brazilian economy and returning the country to a path of growth. It is my starting premise, though, that these reform failures cannot be viewed only as such. When the

Plano Collor failed, it is true that inflation once again skyrocketed. What is not true is that its failure returned Brazil to the pre- Plano Collor status quo. Such a result would have been nearly impossible, as any large reform program is bound to alter the economy and society in some

25 tangible way that persists after the program fails. It is precisely this alteration, if you will, on which I focus. After repeated stabilization and reform failures over the last decade, why was the

Plano Real able to succeed in 1994? How were “an economist and his buddies able to trick the people of Brazil into saving the country from rampant inflation… [with] a crazy, unlikely plan?”29 What had changed that set the stage in Brazil for reform success?

To answer these questions, I assert that it is crucial to consider the lasting effects of earlier efforts at stabilization and reform. Enter into the picture the accumulation of changes in the economy, the government, and society as a result of previous reform and stabilization attempts. Without going into too much detail here (as that is what the case study of Brazil that follows will do), this is the idea to keep in mind when reading the remainder of this thesis: reform program failures do not happen in a social vacuum. A simple premise, but it does not always receive its fair share of attention and analysis.

Even failed attempts at reform are dynamic processes that have consequences beyond being unable to tame inflation permanently. In a most immediate sense, policy-makers are able to observe in many cases what did not work. While it is difficult to find the cure to stabilization and reform ills that had plagued Brazil for decades, there are instances when policy packages have clear lessons to offer of what not to do. In the case of Brazil, it became increasingly clear what did not work as the end of Sarney‟s term approached, and Collor and Cardoso brought different approaches to their stabilization and reform efforts than those upon which Sarney relied (i.e. strictly heterodox shocks without sufficient structural adjustment). Subsequent administrations learned the necessity of structural reform as part of an enduring package of stabilization and reform, and they challenged the status quo of policy proposals. As I alluded to earlier, while the

29 (01/10/2011). How Fake Money Saved Brazil, Planet Money: NPR

26 Plano Collor was indeed another failed heterodox shock program, the privatization and trade opening elements of that plan did not disappear. They persisted, and in so doing they had dramatic effects on society that I will discuss at length in the Brazilian case study. Idealistic as it might sound, a reform program failure may be better viewed as a set-up for future reform success. It may be that reform has to reach a certain absolute or relative (to the country‟s reform experience) level before it can really take off, that accretion of reform in the form of gained political and economic know-how is key in predicting future reform successes. To observe this mechanism in action, we expect to see progressive variations of policy proposals, eliminating failed elements of past reform efforts and incorporating those that worked in addition to new elements. We may also find discourse of policy-makers regarding past attempts and how their plans differ from those failures to be illustrative of the political learning process.

Not only do policy-makers learn from the past (one should hope), but also not all aspects of reform programs necessarily fail when inflation returns. It may be the case that these elements of reform that stick have impacts on society that alter the bargains that have to take place in future reform attempts (e.g. an alteration in the strength of labor or business vis-à-vis each other and the government would affect which actors have the most weight in bargaining over reform measures). In this case, I will look at the labor sector in Brazil, which was affected by the slew of reform efforts enacted through the 1990s, and analyze how these efforts impacted labor and its bargaining position. As Karen Remmer observed,30 stronger labor leads to more demands from this sector that can destabilize reform efforts. Evidence that would support the activation of this channel of the accretion mechanism would be evidence that labor was made weaker by successive reform efforts in Brazil and that labor‟s increasing weakness corresponds with greater

30 Remmer, K. L. (2002). "The Politics of Economic Policy and Performance in Latin America." Journal of Public Policy 22(1): 29-59.

27 reform success without much change in the stabilization and reform plans themselves. These are the premises that I put forward and will proceed to outline for the Brazilian case.

Finally, the third mechanism is that the accretion of reform alters the initial conditions policy-makers face when designing and implementing a reform program. This is related in some ways to the first causal mechanism of political learning, but it focuses more on the tangible aspects of the political and economic spheres. For example, Brazil saw the build-up of official reserves from just over $8.7 billion at the end of Sarney‟s administration in 1989 to over $38 billion in 1994, the year of the Plano Real. As we saw in the Prati-Hamann listing of factors31 conducive to stabilization, high reserve levels have been theorized to foster stabilization and reform success. This type of explicit change in political and/or economic circumstances taking place between one reform effort and the next is evidence of this third mechanism. The political learning mechanism comes into play only when policy-makers actively learned that high reserve levels were necessary for reform success and changed course from prior plan failures accordingly.

While it is impossible to disaggregate the impact that each of these mechanisms has on the final outcome which I measure, the accretion of reform, my case study of Brazil is useful in highlighting when certain mechanisms come into play more than others. I find that political learning has been of the utmost importance in the Brazilian case, and that this may explain a good deal of reform accretion. That said, while it is desirable to identify that one key contributing factor, it is likely that these three mechanisms work in tandem. Leslie Armijo calls attention to these kinds of mechanisms working in tandem with an interpretation of the social

31 Hamann, A. J. and A. Prati (June 2003). "Beating Inflation: The Importance of Luck, Timing, and Political Institutions." Finance and Development Vol. 40(2): 12-15.

28 conflict theory behind inflation whereby “a variant on this interpretation attributes successful stabilization to the combination of an acute crisis, which inspired normally quarreling social actors to cooperate, and policy learning, as many of the same government technocrats participated in successive heterodox stabilization attempts, incrementally modifying each new plan on the basis of the previous failures.”32 It is to the Brazilian case, and the search for evidence supporting these causal mechanisms, that I turn in the next chapter.

32 Armijo, L. E. (2005). "Mass democracy: The real reason that Brazil ended inflation?" World Development 33(12): 2013-2027. Page 4.

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CHAPTER 4 A BRAZILIAN CASE STUDY

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4.1 Transition to Democracy

In crafting my theory of reform implementation and success, it is most illustrative to break up the analysis into two mutually reinforcing components. First, I will lay out the case of

Brazil in detail. This case study analysis will allow me to outline temporal sequencing and causal mechanisms in the Brazilian context and to clearly outline the logic behind my theory of successful reform. Once this theory is fully outlined in the Brazilian case, I will extend my analysis to a multiple-country sample in order to test the effects of my independent variables on the likelihood of reform. This will show whether this theory is suited to the Brazilian situation only, or whether it has ramifications for other countries in the region and says something more generalizable.

The Brazilian masses were witness to chronic inflation for decades, increasing to the brink of on numerous instances, as well as a slew of heterodox and orthodox fixes to this persistent scourge on the Brazilian economy. Given this trajectory of events, it is hardly any wonder that Brazilians were rendered jaded by a seemingly endless string of politicians promising a final fix to their inflation woes. Dramatically increasing inflation occurred simultaneously with the transition to democracy after decades of authoritarian rule. In essence, the 1980s was a rocky decade that left Brazil wrought with instability on numerous fronts. Its nascent democratic system would need to address the ills of the past 20+ years in a much shorter time frame.

In theory, the transition to democracy could have both positive and negative effects of the likelihood of successful reform. Having a new democratic government in place to deal with all

31 the ills left by the authoritarian regime could potentially exacerbate some problems. Leslie

Armijo calls attention to the conventional wisdom that the combination of weak inherited institutions and the increasing number of social actors making spending demands on a new democracy had the effect of contributing to the explosion of inflation witnessed in Brazil in the late 1980s.33 In giving a voice to a comparatively large segment of the citizenry (compared to the group of actors who had a say in politics under military rule), Brazilian politicians stood to become even more beholden to those who elect them. This could make them less willing to sacrifice their electoral chances in the name of fiscal austerity, and the newly enfranchised groups could have their increasing calls for government support met, worsening the country‟s fiscal position. There is some support for this point having salience in Brazil, contributing to the worsening fiscal position of the government at a time when the opposite was called for. As Baer notes, “The root of the resurgence of inflation from the mid-1970s on was a „fight for shares‟ among various socioeconomic sectors, which governments, committed to political opening, were not able or willing to prevent. With the return of civilian governments after 1985, this situation worsened as politicians were mainly interested in using the government to fulfill their electoral ambitions rather than in following consistent economic policies.”34

In bolstering reform efforts, the new democratic government, which gave long- marginalized Brazilians a more solid voice, would have had a greater deal of legitimacy compared to an authoritarian administration just by virtue of it not being the old authoritarian regime. With this legitimacy, the new democratic leaders could run with a stabilization package, and if well-planned and executed, it could engender the support of the citizens even through

33 Ibid. Page 3. 34 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 192.

32 short-term pain. However, the transfer of power to the first „democratic‟ president was not so smooth in Brazil as such a theory would like to see. The first non-military president to take office was José Sarney. He had been elected as Vice-President under Tancredo Neves (by the

Parliament, in an election organized by the outgoing military regime, it should be noted, not by the Brazilian people at large). Neves became ill on the eve of his inauguration and died one month later, leaving his successor Sarney to take up the presidency. So, the first democratic in forty years was not actually elected as president, and he was not directly elected by the people (one of the demands of the Diretas Já protests against the military regime just prior to its agreements to turn power back over to a democratic system).

1985 was a difficult year for the Sarney government. In addition to attempting to consolidate democracy in Brazil, Sarney was forced to confront an enormous stock of debt left by the military regime, corruption, and ever-increasing inflation, which ended 1985 at 226%.35

Even in the face of these mounting difficulties, Sarney worked directly with Argentine President

Raúl Alfonsín to start the process of creating a common market between the two countries with their signing of the Argentina-Brazil Integration and Economics Cooperation Program (or PICE, the Programa de Integração e Cooperação Econômica Argentina-Brasil), which would lead to the creation of Mercosul in 1991 under Collor. It is this kind of piecemeal effort that my accretion of reform theory wishes to isolate as explanatory of future reform success. While committing to greater regional trade and lower tariff barriers would not serve to lower inflation directly or immediately, such steps toward reform cannot go ignored. As I will discuss later,

Brazil was to continue down this path of trade openness with the Treaty of Buenos Aires (1990),

35 World Bank. “The World Bank Open Data – Brazil.” 1980-2000.

33 the Treaty of Asunción (1991), and the Protocol of Ouro Preto (1994). This move toward regional integration and trade openness began not in the 1990s, but back in 1985.

4.2 The Plano Cruzado

By the beginning of March 1986, the economic situation in Brazil demanded more active attention, and Sarney‟s economic advisers advocated for a heterodox shock treatment for inflation. As opposed to the economic orthodoxy endorsed by the IMF which had yet to end inflation in Brazil, a heterodox shock would use price and wage freezes to stomp out inflation by disabling the indexation schemes so ubiquitous in the Brazilian financial system. At this time, the heterodox camp was gaining power in the government, and their diagnosis that Brazil suffered from inertial inflation and that the shock treatment of a heterodox plan could end the vicious cycle of rising prices was replacing remedies calling for orthodox measures that were seen as increasingly difficult to implement for political reasons.36

In preparing for the launch of the Plano Cruzado, the government took a number of actions to give the plan its best fighting chance at success. This entailed addressing areas of monetary and fiscal imbalance.37 In order to better control expenditures, the Treasury Secretariat was created within the Finance Ministry in order to centralize control of public expenditures and the national Treasury budget and the “monetary budget” were partially unified. In order to control the growth of money, the Banco do Brasil‟s “movement account,” which allowed this commercial bank to create base money through an open Central Bank discount facility, was frozen. Additionally, increases in personal income tax rates and tax rates on financial transactions were raised. While this groundwork was laid in advance of the implementation of

36 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 149. 37 Ibid. Page 149.

34 the plan, there was little discussion of the plan itself. As da Fonseca states, “Secrecy was an important aspect of the Plano Cruzado and later unorthodox plans. This was in order to avoid major disruptions in the economy and, particularly, in financial markets.”38

While the Plano Cruzado eventually fell by the wayside, these structural changes had longer-lasting impacts. Centralizing control of public expenditures, unifying budgets, cutting off the money-creating mechanism used by the commercial Banco do Brasil, and demonstrating the importance of increasing tax revenues and reforming the tax system (an enduring problem throughout Latin America) all had important effects on the Brazilian system. These changes made it easier for future governments to follow down the same path and push these sorts of reforms even further, creating a precedent of the need for fiscal prudence that would grow in scope with successive administrations. Finally, Cardoso undoubtedly learned from the failure of the Plano Cruzado and subsequent plans that secrecy did not work. Instead, he would announce his Plano Real a full six months prior to implementation to force its debate by key segments in society and in Congress.

On February 28, 1986, President Sarney introduced the Plano Cruzado in an attempt to rid the country of its inflation problem through the measures enumerated in Table 4.1 below.

TABLE 4.1 Plano Cruzado Measures39 (1) A general price freeze on final goods and services; (2) A wage freeze following a readjustment that set the new real wages at the previous six months’ average plus 8 percent, and 15 percent for the minimum wage; (3) Application of the same formula to rents and mortgage payments, without the 8 percent increase (4) A wage-escalation system, which guaranteed an automatic wage increase each time the consumer price index had risen 20 percent from the previous adjustment or from each labor category’s annual “base date;” (5) Prohibition of indexation clauses for contracts of less than one year (6) Creation of a new currency, the cruzado, which replaced the old cruzeiro.

38 Fonseca, M. A. R. D. (1998). "Brazil's Real Plan." Journal of Latin American Studies 30(3): 619-639. Page 627. 39 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 148.

35

The immediate effects of the Plano Cruzado were spectacular: inflation nearing zero percent, acceleration in economic activity, increased industrial production, and strong external accounts. “Superficially it seemed that Brazil had accomplished the trick of running solid external accounts and maintaining spectacular growth with rising real wages, diminishing unemployment, and insignificant inflation.”40 As promising as the situation appeared, it is clearer in retrospect that a country that had been suffering from for years could not immediately reverse course and manage to both have its cake and eat it too. The Plano

Cruzado’s price freeze and wage increase worked in favor of labor, but these measures also spelled the demise of the plan. The wage increase at the start of the plan planted a seed of inflationary pressure that would ultimately increase inflationary expectations and trigger the wage-escalation system. The wage increase also supported higher economic growth via increased consumer spending. Such spending and economic growth should be accompanied by a government budget surplus according to countercyclical management, but the government continued to run a public sector deficit.

The price freeze led to expected shortages and „premiums‟ on goods that had not been adjusted upward prior to the freeze as many goods had, so they were priced comparatively lower when the freeze was implemented. “Although the Plano Cruzado economists agreed that the price freeze would have to be temporary, they had reached no consensus about how long it should last, since they did not know how long it would take to reverse inflation expectations…

They did fear that premature unfreezing could reintroduce inflationary expectations and bring

40 Ibid. Page 150.

36 about renewed inertial conditions.”41 The government was likely unwilling to carry out price realignments for two reasons: “First, since the freeze came to symbolize the political success of the plan, President Sarney was reluctant to tamper with it, at least until after the crucial

November elections to the new Constituent Assembly.”42 Second, because of the wage trigger mechanism, politicians were unwilling to raise prices and set off this wage increase mechanism.

In addition to this question of the optimal duration of the price freeze, policy-makers had to consider how long and how strictly to maintain the exchange rate peg. At the start of the Plano

Cruzado, Brazil was in a relatively strong external position. But, “there is little doubt that the exchange rate was kept fixed far too long – that the sharp increase in domestic demand and the de facto, if not fully measured, inflation after mid-March meant that the cruzado was increasingly overvalued.”43 This led to a marked deterioration in the trade accounts.

Luiz Carlos Bresser-Pereira, Brazilian finance minister in 1987, remarked that “in designing the plan, two mistakes were made: an unrealistic expectation of „zero inflation‟ and a real wage increase of 8 percent on the day of the freeze even though the increase of real wages during 1985 was already pushing inflation upwards.” 44 He asserts that the plan was technically well-designed, but that two key problems were also underestimated: the dimensions of the public deficit and the internal consequences of the external debt. These are problems that were noted by future stabilization plan authors and implementers, especially Collor and his focus on balancing the budget, and this acknowledgement of factors behind the Plano Cruzado’s failure supports the political learning mechanism in contributing to the success of the Plano Real at a later date.

41 Ibid. Page 153. 42 Ibid. Page 165. 43 Ibid. Page 162. 44 Bresser-Pereira, L. C. (1990). Brazil's Inflation and the Cruzado Plan, 1985-1988. Inflation: Are we Next? Hyperinflation and Solutions in Argentina, Brazil, and Israel. P. S. Falk. Boulder, Lynne Rienner: 57-74. Page 6.

37 Knowing that something had to be done, the government announced the Plano Cruzado

II measures shortly after the crucial November 15 elections. The goal of these measures was to cool domestic demand through price realignments of “middle class” (e.g. automobiles, fuels, cigarettes, alcohol, and sugar) consumer products and increased taxes on them. The Cruzado II also included a crawling-peg exchange rate devaluation and new tax incentives for savers. The

Cruzado II did not have the intended impact of reducing domestic consumption, and indeed the measures served to revive inflation as the trigger mechanism began to function and wages rose.

The yearly inflation rate far exceeded 1,000 percent by the middle of 1987. The Plano Cruzado and its short-lived successor the Cruzado II did not just peter out; they collapsed in a dramatic fashion. “Inflation expectations – and uncertainty – recovered with a vengeance; annualized short-term interest rates reached nearly 2,000 percent in early June 1987. Finally, the Central

Bank‟s international reserve position had fallen so far that the government found it necessary to declare a unilateral moratorium on February 20, 1987.”45

In creating the Plano Cruzado, its designers believed that the inertial component of inflation in Brazil was the predominant driving force behind the phenomenon. This situation could best be described as a “fight for shares” among agents in the Brazilian economy, contributing to increasing inflation. Baer points out that there seemed to be only two ways out of such an inflationary spiral: “One was an orthodox stabilization policy, which could succeed permanently only if certain socioeconomic groups could be made to absorb a decline in their

45 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 166.

38 share of the national income. The other was the creation of a social consensus, which would stop the „fight for shares.‟ The Plano Cruzado amounted to an attempt to choose the second way.”46

“The Plano Cruzado failed rather definitively, and the costs of the failure were high.”47

Included among the economic costs were the drastic fall in government reserves leading to the declaration of the unilateral moratorium in 1987, the dramatic return of inflation, and recession beginning in the first half of 1987 driven by a sharp decline in the purchasing power of labor.

Political costs included loss of national political morale and disillusionment with the democratic government under Sarney after the deliberate postponement of desperately needed adjustment measures until after the November elections.

The lessons of the Plano Cruzado had a tangible effect on future reform efforts. First of all, the large wage increase in favor of labor at the start of the plan was acknowledged as a largely destabilizing factor throughout the program. A lesson to be drawn from this experience was that to implement a stabilization and reform program by buying support from certain social sectors is a dangerous move to make when it comes to plan feasibility and effectiveness. Also key to keep in mind are the structural adjustments enacted prior to the Plano Cruzado’s announcement that included unified oversight over the government‟s budget and cutting off the

Banco do Brasil‟s ability to engage in money creation. While these changes were certainly not sufficient to foster the success of the Plano Cruzado, the fact that they persisted should not be lost.

4.3 Sarney after the Cruzado’s Collapse

46 Ibid. Page 168. 47 Ibid. Page 169.

39 After the failure of the Plano Cruzado, the Sarney government lost direction. Illustrative of this point is the fact that Sarney had three finance ministers and three different stabilization programs after 1986. The focus during much of his tenure in office was on the Constituent

Assembly of 1988, which would set the length of the presidential term. Sarney wanted the

Constituent Assembly to designate a five-year presidential term, and much political capital was spent toward this end. Given that Sarney lost a good measure of public support after the failure of the Plano Cruzado, he was reliant on the Congress elected in 1986 which would form the

Constituent Assembly. Because of this, Sarney would concede to the preferences of Congress in his formation of economic policy. For example, Sarney‟s policymaking team realized after the failure of the Plano Cruzado that controlling the government‟s fiscal deficit was important to the success of stabilization measures. “For political reasons, however, a true fiscal adjustment was not carried out: the executive lacked determination due to its anxiety to have Congress vote in favor of a five-year term and most members of Congress had never sympathized with fiscal restraints.”48

Worsening government budget deficits and soaring inflation contributed to an increasingly chaotic economic situation. Dilson Funaro, finance minister during the Plano

Cruzado was replaced in May 1987 by Luiz Carlos Bresser-Pereira. The next month, Bresser-

Pereira introduced the Plan for Economic Stabilization, known as the Plano Bresser (or the

Bresser Plan). This plan entailed short-term (90-day) price and wage freezes that allowed for price and wage readjustments. “This flexibility was also applied to public sector prices and the exchange rate, in order to avoid two of the major problems of the Cruzado Plan: the deficits of

48 Ibid. Page 175.

40 public enterprises and the overvaluation of the currency,”49 an instance of policy-learning being put into action. The Plano Bresser also aimed to reduce the public deficit and to curb a domestic consumption boom by keeping interest rates higher than the rate of inflation. Clearly, much had been learned from the downfall of the Plano Cruzado, especially when it came to the importance of the public sector deficit, but by October 1987, inflation had once again reached double-digit monthly figures. “Along with the intensification of the distributive conflict resulting from the demand for the re-composition of wages and the rise of public utility and other controlled-sector prices prior to the introduction of the plan, the basic problem was the failure to control the budget deficit.”50 This lack of control over the deficit is largely attributable to the fact that

Sarney was simultaneously lobbying Congress for the five-year presidential term and was therefore unwilling to curb the government spending on which congressmen depended for gaining constituent support. The Plano Bresser completely failed in stabilizing the economy, and it did not leave much in the way of reform legacy, but it did demonstrate that some economic policy learning had occurred in designing stabilization programs.

Bresser-Pereira notes that the Plano Bresser was never indended to be more than an emergency measure meant to avoid hyperinflation and that it should have been followed by

“some reasonable solution for the foreign debt problem, a strong fiscal adjustment, and a new stabilization plan.”51 Lacking the necessary political support for these measures, Bresser-Pereira resigned in December 1987 after the failure of the plan bearing his name, and he was replaced for the rest of Sarney‟s term by Mailson da Nobrega. There had been economic learning about necessities for stabilization success, but political learning had yet to catch up. Nobrega initially

49 Ibid. Page 176. 50 Ibid. Page 176. 51 Bresser-Pereira, L. C. (1990). Brazil's Inflation and the Cruzado Plan, 1985-1988. Inflation: Are we Next? Hyperinflation and Solutions in Argentina, Brazil, and Israel. P. S. Falk. Boulder, Lynne Rienner: 57-74. Page 1.

41 rejected the use of shock treatment and focused instead on austerity measures in a gradualist inflation-reduction strategy that became known as the „rice and beans‟ (arroz com feijão) strategy due to its lack of any strong structural reform measures. Inflation continued increasing, though, and “the social unrest provoked by this situation led union leaders and employers, subsequently joined by the government, to attempt a Brazilian version of the successful Mexican

„Social Accord.‟”52 Due to a number of factors, a lack of political support among them, this attempt failed to reconcile the interests of societal actors. While no social pact came about under the Sarney government, the example of the attempt at one would be crucial in designing the successful Plano Real.

Nearing the end of its term, the Sarney government decided in the beginning of 1989 to try its hand at one more heterodox shock, the Plano Verão. Its principal measures included those listed in Table 4.2.

TABLE 4.2 Plano Verão Measures53 (1) A new price and wage freeze; (2) The abolition of indexing, except for savings deposit accounts; (3) The introduction of a new currency, the “Cruzado Novo,” equivalent to 1,000 Cruzados; (4) An attempt to restrain monetary and credit expansion (increasing reserve requirements to 80 percent; reduction of the length of consumer loans from 36 to 12 months; suspension of debt- equity swap operations); (5) A 17.73 percent devaluation of the exchange rate.

The Plano Verão was the shortest lived of the stabilization programs attempted under Sarney. It may be fair to say that the Brazilian population was becoming accustomed to these price and wage freezes and were thus less willing to believe they would work each time. Baer agrees with this conclusion in his statement that “The low credibility of these policy instruments [heterodox

52 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 177. 53 Ibid. Page 177.

42 shocks] and the negative expectation of economic agents resulted in the use of extralegal measures to raise prices.”54 Whereas Sarney had been able to convince the public of the feasibility of the Plano Cruzado and even rallied them to report illegal deviations during its price freeze, no such faith in such measures could be found in Brazilian people any longer. The Plano

Verão had failed, the budget deficit was on an upward trend (fuelled in part by the provisions in the 1988 Constitution requiring the federal government to transfer a higher percentage of its fiscal resources – 21.5 percent of the income tax and manufactured goods tax – to the states and municipal governments without including a provision for the simultaneous transfer of the federal government‟s obligations), and inflation teetered on the brink of hyperinflation. Given this scenario, it is no wonder that the next president, , started day two of his presidential term by announcing a radical new stabilization and reform program.

4.4 Enter Collor and the Plano Collor

Fernando Collor de Mello was elected in the first popular presidential election since

1960. Prior to the 1989 election, political participation had been comparatively low, but with the transition to democracy and moves toward greater enfranchisement, participation in the 1989 presidential election was at 80 percent.55 As Armijo points out, the median voter was poor, and poor voters always desire low inflation. The tide had turned in who politicians had to please to be elected, and it was no longer a small body of political elites that held all the political power.

Collor was elected president as a dark horse candidate, and his style has been likened to that of classic Latin American populists. He received a great deal of electoral support from the poor, and this leads to a puzzle of sorts. As elaborated by Armijo, the puzzle is “why so many recent Latin

54 Ibid. Page 178. 55 Armijo, L. E. (2005). "Mass democracy: The real reason that Brazil ended inflation?" World Development 33(12): 2013-2027. Page 12.

43 American candidates with strong electoral support from the poor have, as in the case of Brazil‟s

Fernando Collor or Argentina‟s Carlos Menem, pursued market-oriented, neoliberal economic reforms once in office.”56 It would appear that the voters had been duped and that Collor had designs for neoliberal reform from day one, but that does not mean that the voters did not vote according to true preferences.

While data on intentions to vote prior to the 1989 election broken down by income is scarce, Armijo presents results from a national study by the DataFolha polling agency in

December 1989 (one week before the runoff elections between Collor and the Worker‟s Party

(PT) candidate Luiz Inácio „Lula‟ da Silva). According to these results, broken down into three income groups, those in the poorest income group expressed preference for Collor, while those in the two higher income groups supported Lula (those in the highest income group actually had the strongest preference for Lula). These results suggest that the more neoliberal candidate was supported by the poorer voters, while the labor candidate was supported by wealthier voters. This calls into question the standard assumptions on the preferences of the poor in choosing their politicians.

White it has been noted that the poor traditionally support politicians who offer material benefits to their group, it is important in the Brazilian case to separate the urban formal sector labor from the true underclass, which hold different interests. The true underclass has “always been largely outside the net of state-orchestrated jobs, indexation, and social welfare benefits,”57 and consequently stands to benefit little from increased traditional government spending. What would truly be of value to this underclass is the ending of inflation, which would allow the

56 Ibid. page 12. 57 Ibid. Page 13.

44 money of people without access to indexation mechanisms to retain its value and contribute to a rise in real wages by virtue of paychecks not being eaten away by inflation. The poor supported

Collor in his quest to end inflation, regardless of the policy orientation that would achieve those results.

In light of these kinds of preferences among the newly enfranchised poor, Schneider‟s observation that the increasingly chaotic inflationary atmosphere contributed to a consensus that the incoming government would have to take drastic actions makes sense. “Collor‟s austerity program consequently provoked less opposition than comparable measures had in the past, even though the social costs were higher. Similarly, the successive and accumulated failures of policies throughout the 1980s opened the possibility for (and weakened resistance to) a profound shift in development strategy.”58 Juxtaposed with Sarney‟s lack of economic direction after the

Plano Cruzado, Collor did indeed have a dramatic plan for the economy from day one. In the

Plano Collor, Collor combined stabilization measures with reforms meant to modernize and liberalize the Brazilian economy. Immediately after his inauguration in March 1990, Collor announced the Plano Collor, which consisted of the measures enumerated in Table 4.3.

TABLE 4.3 Plano Collor Measures59 (1) Eighty percent of all deposits in the overnight market, transaction and savings accounts that exceeded Cr$ 50,000 (equivalent to US$ 1,300 at the then prevailing exchange rate) were frozen for eighteen months, receiving during this period a return of the prevailing rate of inflation plus 6 percent a year. (2) A new currency was introduced. The Cruzeiro substituted the Cruzado Novo (Cr$ 1.00 = NC$ 1.00). (3) An extraordinary, once-and-for-all tax on financial transactions (IOF) was charged on the stock of financial assets, on transactions in gold and stocks, and on the withdrawals from savings accounts. (4) Initial price and wage freeze, with posterior adjustments following governmental determination based on expected inflation. (5) Elimination of various types of fiscal incentives – for imports, exports, agriculture, the North and

58 Schneider, B. R. (1991). "Brazil under Collor: Anatomy of a Crisis." World Policy Journal 8(2): 321-347. Page 321. 59 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 180.

45 Northeastern regions, and the computer industry; application of income tax on profits from stock market operations, agricultural activities and exports; and the creation of a tax on wealth. (6) Immediate indexation of taxes (on income and on manufactured products), forcing their adjustment to inflation the day after the transaction is made. (7) Implementation of disciplinary measures and new regulatory laws on financial operations, seeing to substantially reduce tax evasion. (8) Increase in the price of public goods (e.g. 57.8 percent increase in the price of gas, 83.5 percent in postal services, 32 percent for electricity and telephones, and 72.28 percent for wages). (9) Liberalization of the exchange rate and the adoption of various measures to promote a gradual opening of the Brazilian economy to external competition (10) The extinction of a number of federal government institutes and an announcement of the government’s intention to lay off about 360,000 public sector workers. (11) Preliminary measures to institute a process of privatization.

The Plano Collor made use of some of the heterodox measures previously applied in the

Brazilian context, but it also contained a number of novel properties that set it apart from previous stabilization and reform attempts. A number of new tax and legal provisions were put in place that would alter the structure of the Brazilian economy in the years to come (even after the failure of the stabilization aspects of the Plano Collor). The Plano Collor was not merely a price freeze, but rather it contained five distinct elements as enumerated by Zoninsen:60 a monetary reform, a fiscal program, short-term wage and price freezes, trade liberalization, and the privatization of state-owned enterprises. While not all elements of the plan were ultimately successful, its design and implementation did have lasting effects on all three accretion mechanisms discussed earlier. Most important in my consideration of accretion of reform, the trade liberalization and privatization projects set in motion under this plan would have far- reaching structural effects on the government and society. In addition, the Plano Collor embraced the necessity for fiscal reform while also demonstrating the difficulty in credibly carrying out such a policy and successfully reversing expectations about the government deficit.

60 Zoninsein, J. (1994). "Financial Reform, Control of Inflation, and State Intervention: Lessons from the Brazilian Experience." The Developing Economies 32(3): 331-349. Page 343.

46 “Despite the approval of the initial set of measures that constituted the stabilization plan,

Collor‟s minority position in the political sphere and his imperious personal style made it difficult to attract the congressional support necessary for some of the structural reforms.”61

Collor‟s political weakness was especially demonstrated in the failure of his government in implementing definitive fiscal adjustments, which required changes in the constitution to be approved by Congress. The inflation stabilization measures set in place also began to show weaknesses from almost the very start, and by July inflation started to rise yet again. In February of 1991, as inflation continued to accelerate, Collor‟s finance minister Zélia Cardoso de Mello

(no relation to the president) announced a set of measures that came to be known as Collor II. Its strategy was one of limited financial reform and a continued quest for fiscal austerity. Collor II did have the short-term impact of lowering prices, but before the long-term effects of the plan could be felt, the Zélia Cardoso economic team was replaced in May 1991. “The principal reason for the change in the Economics Ministry can be found in the increasing weakness of the political support of the team of Zélia Cardoso, which was looked upon as excessively centralizing and authoritarian. The strong interventionism of the Plano Collor I (especially the freezing of financial assets) and its eventual failure, the imposition of another price freeze and a new form of indexation had a strong negative impact on the private sector and the media.”62

Replacing Zélia Cardoso de Mello was Marcilio Marques Moreira who was immediately popular with the private sector due to his background as a former ambassador to Washington and as a banker, along with his declaration against any type of shock treatments. His new economic team declared that it would continue with the privatization and trade opening processes begun

61 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 174. 62 Ibid. Page 184.

47 under the Plano Collor I, with several privatizations beginning in October 1991. There was also progress on the trade liberalization front. As can be seen in Table 4.1 below, the average tariff in

Brazil halved from 1987 to 1991, and it would continue on this downward trend through the early 1990s.

TABLE 4.4 Brazil Average Import Tariffs (percent)63 Average Tariff Standard Deviation 1987 51 26 1988 41 17 1989 35 20 1990 32.2 19.6 1991 25.3 17.4 1992 21.2 14.2 1993* 17.1 10.7 1994* 14.2 7.9 *Projected Source: Perspectivas da Economia Brasileira 1992 (Brasilia: IPEA, 1991), pp. 67 and 76

While the Plano Collor did eventually fail, I again stress the importance of observing what changes implemented under Collor persisted and what impact these changes had on

Brazilian society and the prospects for reform in the future. Its focus on lowering the government deficit had limited success, but Collor‟s government left a more permanent legacy in its reduction of the debt as a proportion of GDP (from 22.2 percent in 1989 to 16.8 percent in 1990 and 12.2 percent in 199164). This clearly altered the initial conditions for the Plano Real in a beneficial way. Earlier I discussed the Argentina-Brazil Integration and Economics Cooperation

Program signed by President Sarney in 1985. The turn of the decade saw an increasing focus on regional integration initiatives. President Collor signed the Treaty of Buenos Aires in June 1990, which “adopted an approach to trade liberalization that emphasized an automatic linear and

63 Ibid. Page 184. 64 Ibid. Page 196.

48 universal mechanism of tariff elimination”65 in Brazil and Argentina. These commitments to trade liberalization were extended to include Paraguay and Uruguay, creating the basis of the

Common Market of the South (MERCOSUL) with the signing of the Treaty of Asunción in

March 1991.

While unable to offer a permanent solution to Brazil‟s inflation, Collor did initiate a number of important neoliberal reforms that “would play a role in building support for fiscal restructuring during the Cardoso administration.”66 Opening the economy and engaging in structural reforms the way Collor did could not leave the dynamics of Brazilian society unchanged. Trade liberalization forced long-protected sectors of the economy to confront the demands of global competition which led to decreased exports and increased imports. This provoked social unrest, especially among government workers who faced this increasingly competitive atmosphere while simultaneously confronting the possibility of having their own jobs privatized (with the consequent risk of seeing many of those jobs eliminated). A government policy of forced competitiveness weakened labor‟s position in the economy (as unemployment would increase as firms failed to be sufficiently competitive and as inefficient government business were privatized). Such a weakening of labor serves to make further reforms more likely, since a traditionally vocal opponent to such reforms has less leverage.

In addition to this groundwork of successful structural reform, “Collor and Franco

[Collor‟s vice president and successor] practiced techniques that enhanced the powers of the presidency in the economic reform process. They used their line-item veto authority, the power

65 Bouzas, R., P. D. M. Veiga, et al. (2002). In-Depth Analysis of Mercosur: Integration, Its Prospectives, and the Effects thereof on the Market Access of EU Goods, Services, and Investment, Observatory of Globalisation - University of Barcelona. Page 12. 66 Montero, A. P. (2001). "Competitive Federalism and Distributive Conflict in Democratic Brazil." Page 17.

49 to issue and reissue provisional measures, and the presidential prerogative to shape annual budgets as the primary mechanisms to implement reforms.”67 This precedent of the exercise of executive authority would come to help Cardoso in his workings with Congress and state governors upon taking office in 1994. An observation by Schneider is also noteworthy: “The failure to achieve a [societal] agreement demonstrated most clearly the fundamental flaw of the

Plano Collor: the lack of negotiated mechanisms to induce economic agents to collaborate.”68

Sarney had tried to achieve a measure of social consensus but failed. Collor attempted the same, but his lack of connection to the political establishment and his antagonism toward key business and labor actors precluded any societal consensus. Cardoso learned from these examples that achieving a „social pact‟ would be necessary for stabilization and reform program success, but he also learned the difficulties inherent in such a process. As Weyland observes, “Whereas Collor confronted – and antagonized – clientelist politicians, rent-seeking interest groups, and powerful state governors, Cardoso has sought to negotiate with them.”69

“With the failure of stabilization attempts and accusations of widespread corruption, which resulted in an impeachment process in Congress, Collor‟s government lost its economic and political leadership capacity.”70 It is true that Collor left office disgraced and having failed to stabilize the Brazilian economy, but, as demonstrated, he left a legacy of reform. Former finance minister Bresser Pereira perhaps sums up Collor‟s lasting contributions best:

O governo Collor mudou a agenda política do país, pois conseguiu implementar reformas corajosas e muito necessárias, e buscou o ajustamento fiscal. Embora outras tentativas tenham sido feitas desde 1987, foi durante o governo Collor que as velhas idéias nacional-desenvolvimentistas foram efetivamente

67 Ibid. Page 17. 68 Schneider, B. R. (1991). "Brazil under Collor: Anatomy of a Crisis." World Policy Journal 8(2): 321-347. Page 332. 69 Weyland, K. (1997). "The Brazilian State in the New Democracy." Journal of Interamerican Studies and World Affairs 39(4): 63-94. Page 80. 70 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 174.

50 enfrentadas e combatidas (...) por um programa corajoso de reformas econômicas orientadas para a liberalização comercial e a privatização.71

Or, roughly translated:

The Collor government changed the political agenda of the country, because it succeeded in implementing brave and very necessary reforms, and it pursued fiscal adjustment. While other attempts had been made since 1987, it was during Collor‟s government that old national-developmentalist ideals were effectively confronted and fought… with a bold program of economic reforms oriented toward commercial liberalization and privatization.

Collor left office under poor economic and political circumstances, but he had effectively challenged the old Brazilian models of development and helped push Brazil onto the more liberal course that would ultimately bring the economy out of its inflationary spiral and toward sustainable growth and development.

Collor made a quick rise in politics to the presidency as a dark horse candidate, perhaps reflecting the Brazilian populace‟s disdain for the first set of democratic politicians who ruled under Sarney. Just as rapid was Collor‟s fall from political grace. With the failure of his radical stabilization program, he lost most of whatever political credibility he had, and without a solid political coalition behind him, Collor lost room to maneuver. His administration enmeshed in a number of political and corruption scandals, Collor was implicated in one such scandal and resigned in December 1992 when it appeared likely that he would be impeached. Into this tumultuous political situation entered Vice President Itamar Franco.

4.5 Itamar Franco’s Presidential Interlude: an Unlikely Watershed Moment

Itamar Franco assumed the presidency amid a once-again deteriorating economic and political climate. Inflation was on the increase still, GDP took a dip in the first quarter of 1993, and the opposition of certain segments of the population to the privatization program put the

71 Nascimento, R. S. d. S. d. "A POLÍTICA ECONÔMICA EXTERNA DO GOVERNO COLLOR: LIBERALIZAÇÃO COMERCIAL E FINANCEIRA." Page 2.

51 whole process on hold for months. Initially, “it took Franco over four months to resume the privatization program, and it also took a considerable amount of time to switch from a nationalistic stance vis-à-vis foreign capital to a more welcoming attitude.”72 Finally, in May

1993, Franco appointed Fernando Henrique Cardoso, an accomplished scholar, as finance minister.

4.6 Fernando Henrique Cardoso: A Savior among Men

Brazilian economist Edmar Bacha, the „father of the Plano Real,’ recalls an early conversation with newly appointed finance minister Cardoso. "He said, 'Well, I've just been named the finance minister. You know I don‟t know economics, so please come to meet me in

Brasilia tomorrow,' Bacha recalls. I was terrified."73 Soon after taking office, Cardoso announced his Program of Immediate Action in June 1993, which was a set of emergency measures aimed at attacking tax evasion, quickening the privatization program, recovering money owed to the federal government by state governments, and bringing state banks under tighter control to prevent them from printing money.74 It had become increasingly clear since Collor‟s administration that a crucial element in solving Brazil‟s inflation woes was a lasting, structurally- driven fiscal adjustment (structurally-driven as opposed to one-shot measures that increase revenue for a short, foreseeable time and then lose effect). As Weyland points out, “the minister and his aides realized that a more comprehensive effort was indispensable.”75 After ruling out a muddling through gradual approach and further attempts at shock therapy, Weyland affirms that

72 Baer, W. (2001). The Brazilian Economy: Growth and Development. Westport, CT, Greenwood Publishing Group, Inc. Page 187. 73 (01/10/2011). How Fake Money Saved Brazil, Planet Money: NPR 74 Flynn, P. (1996). "Brazil: The Politics of the 'Plano Real'." Third World Quarterly 17(3): 401-426. Page 403. 75 Weyland, K. (2002). The Politics of Market Reform in Fragile Democracies: Argentina, Brazil, Peru, and Venezuela. Princeton, NJ, Princeton University Press. Page 221.

52 Cardoso and his team opted for a “gradual shock designed to enact some crucial elements of the drastic option, yet in a sequenced and flexible fashion.”76

Relations with Congress were not smooth, but Congress did agree to start a constitutional review in October 1993, seen as a necessary precondition for a successful stabilization and reform program. Congress decided to focus on seven issues, all of which became pillars in the

Plano Real, and many of which would remain unsolved through the 1990s: fiscal reform, to reduce the number of taxes; a change in the distribution of income and expenditure between the federal government, states, and local governments; reform of the social security system; the question of state monopolies; reform of the electoral and party systems; and civil servants and their job stability.77 “In his sequential approach, Cardoso – learning from the failures of earlier adjustment efforts – pushed first for an alleviation of the state‟s fiscal problem,”78 a move which went unsupported by the IMF, which saw this initial fiscal adjustment as insufficient.

In December of 1993, Cardoso embarked upon the journey that would culminate in not only the successful taming of Brazilian inflation, but also in his ascendency to the presidency.

Cardoso took a different approach to the Plano Real compared to the planning and implementation of prior stabilization and reform plans. He “approached stabilization primarily as a political challenge, rather than an economic puzzle.”79 His Plano Real aimed to avoid some of the pitfalls that brought down previous inflation stabilization plans, such as the use of sudden price freezes whose ultimate effects on inflation were merely transitory. Also unlike previous plans, which were often decreed without much notice of coming measures, the Plano Real was

76 Ibid. Page 221. 77 EIU (1993). Country Report, Brazil, 4th Quarter 1993. Page 7. 78 Weyland, K. (2002). The Politics of Market Reform in Fragile Democracies: Argentina, Brazil, Peru, and Venezuela. Princeton, NJ, Princeton University Press. Page 222. 79 Armijo, L. E. (2005). "Mass democracy: The real reason that Brazil ended inflation?" World Development 33(12): 2013-2027. Page 14.

53 announced six months prior to being put into action and it was to be implemented gradually in conjunction with discussion of the plan‟s measures in Congress. Cardoso knew the importance of politics, and he used the coming presidential elections to rally centrist and rightist politicians to support his plan, since further economic deterioration would work to the benefit of Lula, the candidate to beat as well as leader of the Worker‟s Party. In helping to solve the social deadlock that prevents reform success, Cardoso‟s plan allowed for an initial wage benchmark mechanism accepted as fair by the actors involved, and this fostered negations that “helped greatly in solving the collective action dilemma embodied in the long-running struggle for shares.”80 This mechanism supports the mechanism of altered social negotiations positioning having explanatory power in the Plano Real’s success.

In attempting to build this „social pact‟ behind the Plano Real, Cardoso was achieving what his predecessors could only contemplate. Roxborough points out that “there had been two serious attempts to forge a social pact in Brazil. The first was during the Sarney government and was largely coincident with the Plano Cruazdo. The second came in late 1990, as the Collor de

Mello government had difficulty in removing inflation from the system with orthodox measures.”81 In the first attempt, the government was torn over how to interact with labor, and a social pact went unrealized. Collor‟s government remained aloof from many organized interests, and consequently, misguided attempts at a social pact yielded no success. Cardoso recognized these failures and created an arena for dialogue from the inception of the Plano Real. He used government-mediated negotiations among societal sectors to even out inflation-fuelling distortions and to gain the acquiescence of trade unions and other government ministers, and the

80 Ibid. Page 14. 81 Roxborough, I. (1992). "Inflation and Social Pacts in Brazil and Mexico." Journal of Latin American Studies 24(3): 639-664. Page 652.

54 government also used reduced trade barriers to discipline domestic business with the threat of cheap foreign imports.82

TABLE 4.5 The Plano Real’s Fiscal Adjustment Measures83 (1) An across-the-board tax increase of 5 percent; (2) A newly created Social Emergency Fund, which received 15 percent of all tax receipts and would help in making a fiscal adjustment on a temporary basis; (3) Spending cuts on government investments, personnel, and state companies of about US$ 7 billion

The Plano Real had two primary foci: (1) a fiscal adjustment, achieved through the measures described in Table 4.5 above; and, (2) a new indexing system, introduced in February

1994, that would gradually lead to a new currency. The virtual currency of the indexing system, called the Unit of Real Value (or URV), was not a physical currency. It was tied to the US dollar, and it allowed the architects of the Plano Real to reintroduce the value of goods in the Brazilian economy. All prices, contracts, and taxes were denominated in URVs alongside the current inflation-adjusted cruzeiros reais price. So, while the price in cruzeiros reais of a gallon of milk might change daily, its price in URVs was constant. Since people were paid in URVs and they made purchases in URVs, they began to associate the real value of things with this virtual currency, and they could be sure that those values would remain constant. As soon as the plan‟s architects believed the Brazilian people had regained a sense of the value of the goods they purchased and had faith in the value of the URV, they introduced the new real currency: the real.

On July 1, the government introduced the real, equal to 1 URV. In tandem with this new currency, the government adopted a strict .

82 Weyland, K. (2002). The Politics of Market Reform in Fragile Democracies: Argentina, Brazil, Peru, and Venezuela. Princeton, NJ, Princeton University Press. Pp. 221-225. 83 Amann, E. and W. Baer (2000). "The Illusion of Stability: The Brazilian Economy Under Cardoso." World Development 28(10): 1805-1819. Page 1806.

55 Cardoso resigned from the position of finance minister in April 1994, before the final stage of the Plano Real was even set into motion with the introduction of the new currency in

July, in order to run for the presidency. Well into June 1994, Lula was the frontrunner in the presidential campaign. Cardoso was not doing well, partially because of his alliance with “the

PFL and the political right, which cost him much credibility on the left-of-center.”84 Cardoso, unsure himself about the continuing success of his Plano Real and its ability to carry him to victory, allied himself with the right and a number of powerful traditional political bosses, further alienating himself from the left-of-center by “speaking the language of change and reform… while associating himself with some of the worst traditions of Brazil‟s political system.”85 In the end, though, Lula was overtaken by Cardoso by September, the third month of single-digit monthly inflation, when Cardoso achieved support of 45 percent to Lula‟s 25 percent.86 “Initially, Cardoso was slightly more popular with middle and upper income voters, but as the election neared there was very little difference by income group in his support, which reached around 48 percent in each of the three income groups surveyed on September 29, 1994 by DataFolha.”87 Cardoso, the social democrat of the Social Democratic Party, offered hope for stability and economic progress through his set of neoliberal reforms, and the Brazilian population clearly supported him and his methods.

Cardoso and his stabilization plan implemented earlier in the year received a popular mandate with his election in October 1994, “giving the unprecedented support of the nation to the plan which he had already launched and to the program which he further elaborated during

84 Flynn, P. (1996). "Brazil: The Politics of the 'Plano Real'." Third World Quarterly 17(3): 401-426. Page 405. 85 Ibid. Page 405. 86 Brooke, J. (September 14, 1994). Taming of Inflation Buoys Centrist in Brazil Polls. New York Times. New York. 87 Armijo, L. E. (2005). "Mass democracy: The real reason that Brazil ended inflation?" World Development 33(12): 2013-2027. Page 15.

56 his election campaign.”88 People had faith in the stability provided by Cardoso and his stabilization plan, evidenced by the 1995 LatinBarometer. According to this data, when asked what the most important problem in Brazil was, only 3 percent indicated inflation or rising prices. However, many of Cardoso‟s reform plans, such as public sector job reform, fiscal reform, and social security reform were not only highly controversial but also required a three- fifths vote in Congress to amend the constitutional articles addressing these issues. Cardoso made the political decision to approach these issues one-by-one, starting with the least controversial. As one can imagine, this approach entailed a painfully slow political process that continued long after Cardoso‟s administration.

Inflation embarked on a downward trend beginning with the introduction of the Plano

Real. This price stability was heavily reliant on the maintenance of a high exchange rate, which was possible only as a result of the increasingly open nature of the Brazilian economy. The policy of economic opening pursued by Collor was paying dividends two presidents later.

Average tariffs fell from 32.2 percent in 1990 to 14.2 percent in 1994 (see Table 4.4 above).

While this use of the exchange rate to maintain price stability worked in the short run, a long run fix would require more fundamental fiscal adjustments that required constitutional changes (and were thus unfeasible in the short run). Try as he might, Cardoso was unable to overcome the political obstacles to implement stringent fiscal reform that learning from past failures would dictate as necessary for the ultimate success of the Plano Real. Not until an IMF adjustment package was necessitated in 1998 was progress finally made toward Congressional approval of more basic fiscal reforms. Working through negotiation rather than imposition on many of these structural reform issues means that results are slow to materialize.

88 Flynn, P. (1996). "Brazil: The Politics of the 'Plano Real'." Third World Quarterly 17(3): 401-426. Page 406.

57 Dramatically decreased inflation was accompanied by substantially larger fiscal and current account deficits. Prior to the Plano Real it had been “relatively easy to control real public sector expenditures with the aid of price increases, by delaying the moment of actual spending.

Inflation facilitated management of intra-government political disputes for resources.”89 This would force the Cardoso administration to address the issue of state fiscal profligacy and assert central government dominance over spending.

Despite these troubles post- Plano Real, inflation remained in check. As indicated above, further reform efforts under Cardoso were piecemeal and belabored at best, especially as the fear of slipping back into inflation gave way to belief in stability. Without the specter of inflation ever-lurking nearby, it was difficult to use the claim that structural reforms were necessary for stability (see Table 4.6 below for an outline of reform measures introduced after the Plano Real).

Despite this, it is evident that reform measures that were introduced much earlier under Sarney and Collor helped pave the way for successful reforms and stabilization under Cardoso. Cardoso learned the importance of social negotiation and transparency in program design and implementation. Without unified oversight of the government‟s budget and the cutting off of money creation by the commercial Banco do Brasil under Sarney, Cardoso would have had a much more labored battle with Congress to implement his fiscal austerity measures and strict monetary policy. And without the trade opening and privatization programs inaugurated in earnest under Collor, Cardoso would have been left without his stabilization anchor of the high exchange rate and the freedom to run with even more high-profile (and government budget cost- cutting) privatizations. The accretion of previous reforms of the Brazilian system clearly helped

89 Pinheiro, A. C., F. Giambiagi, et al. (2001). Brazil in the 1990s: A Successful Transition?, BNDES Textos para Discussao 91. Page 15.

58 pave the way for the success of the Plano Real, and I turn now to quantitative tests of this hypothesis.

TABLE 4.6 A Chronology of Key Economic Reforms and Events, 1994-9990

July 1994 The Real is introduced successfully as Brazil‟s new currency. January President Fernando Henrique Cardoso takes office. 1995 January The Mercosul Common External Tariff comes into force, liberalizing trade further. 1995 February Law 8987 is passed, regulating the granting of concessions to private companies to run public 1995 utilities. This legislation sets the scene for a new wave of privatizations. November Constitutional Amendment No. 9 is approved, opening up oil exploration and production to domestic 1995 and international private capital. Mid-1995 Presentation of Constitutional Amendment no. 175 to Congress aimed at simplifying taxation system. This initiates a new round of congressional negotiation over tax reform, especially of indirect tax. February Complementary Law 85 approved, establishing COFINS, a tax aimed at improving the financial state 1996 of the social security system. April 1997 Law 9630 passed, setting new rates of social insurance contributions for active and inactive public servants. March A constitutional amendment is approved tightening employment conditions for public service 1998 workers. To be effective, enabling legislation needs to be passed, and, as of January 2000, this was still under debate in Congress. October President Fernando Henrique Cardoso is elected for a second term. 1998 October Legislation partially approved setting tougher conditions for social security contributions. For 1998 nonpublic sector workers contributing to the INSS social insurance scheme, minimum contribution periods and retirement ages are set. November Follow a period of sustained downward pressure on the Real and a hemorrhaging of reserves, the 1998 IMF launches a rescue package. An emergency fiscal stabilization plan is approved by Congress with the emphasis on tax rises and spending cuts. January The Real‟s peg with the U.S. dollar is finally abandoned and the Brazilian currency subsequently 1999 devalues sharply. January Legislation is passed obliging retired civil servants to make social security contributions. This 1999 measure was ruled unconstitutional by the Supreme Court in September 1999, forcing the government to introduce a new constitutional amendment (which as of January 2000 had not yet been approved) and emergency tax rises. November Legislation is passed introducing actuarial rules in the calculation of INSS benefits to private sector 1999 workers. The effect of this legislation is to introduce greater correspondence between social security benefits and contributions. January Crucial legislation affecting tax reform, fiscal arrangements at state and municipal level (i.e. the Law 2000 of Fiscal Responsibility), and public sector employment conditions is still before Congress. Rapid passage of this legislation appears unlikely.

90 Amann, E. and W. Baer (2000). "The Illusion of Stability: The Brazilian Economy Under Cardoso." World Development 28(10): 1805-1819. Page 1813.

59

CHAPTER 5 A QUANTITATIVE APPROACH

60 I have now demonstrated my theory of reform accretion for the case of Brazil in particular. There are observables of political learning, changing social dynamics, and altered initial conditions after failed stabilization and reform attempts that all support my thesis that an accretion of knowledge and reforms contributes to successful inflation stabilization and reform programs. It is my intention here to explore the implications of my theory for a wider sample of

Latin American countries, many of which experienced similar inflation sagas as Brazil. Treated as my sample in this section are: Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico,

Paraguay, Peru, Uruguay, and Venezuela. Interestingly, not all of these countries won their battles with inflation at the same time, indicating that there is indeed something internal that greatly affects inflation stabilization and reform program success rather than generalized trends carrying across the region.

5.1 The Data

In constructing the dataset I use to test my theory of the importance of prior reform for the success of inflation stabilization, it was necessary to design a mechanism that measures the causal effect of reform index scores on not only bringing inflation down but also keeping it low.

In order to give my theory a fair and straightforward test, I focused on data for inflation and three distinct indexes measuring structural reform. My dataset spans from 1980 through 2005, the last year for which reform index scores are available. As many of the countries in my sample experienced bouts of extreme hyperinflation, it was necessary to transform the data I collected on inflation to reduce its skewedness. I used the Dreher et al. method to normalize my data on

61 inflation which reduces the influence of extreme observations.91 It is then necessary to define what a „big fall‟ in inflation is and what a „sustained fall‟ looks like in the data. In order to approach these concepts, I calculate the moving average and standard deviation of inflation in each country separately. I then define a „big fall‟ year as one in which the observed level of inflation is less than the moving average minus the standard deviation for that same year. This is a variable that takes on a value of one in the case of a „big fall‟ and a value of zero otherwise. I define a „sustained fall‟ year as one in which that year and at least the next two years achieve a one in the „big fall‟ variable. In picking three years as the cutoff point for a „sustained fall,‟ my motivation is that after that amount of time I have generally not discovered instances of stabilization program failure.

It is illustrative to demonstrate how my „sustained fall‟ variable does indeed isolate years commonly recognized as key in countries‟ battles against inflation and toward greater reform.

Table 5.1 lists the countries and years in which a „sustained fall‟ was initiated.

Table 5.1 Sustained Fall Observations Country Year(s) Argentina 1991 Bolivia 1987 Brazil 1995 Chile 1992 Colombia 1982, 1993 Ecuador 2002 Mexico 1989, 1997 Paraguay 1995 Peru 1992 Uruguay 1994 Venezuela 1999

91 Dreher, A., J.-E. Sturm, et al. (2008). "Does high inflation cause central bankers to lose their job? Evidence based on a new data set." European Journal of Political Economy 24(4): 778-787. Page 780. This transformation is done via the following formula: .

62 Since it is my premise that a key factor contributing to the ultimate success of the Plano

Real in 1994 is the momentum set up by previous largely-failed reform efforts, it is necessary to construct an independent variable that can measure the progress in economic reform achieved by these failed plans. Instrumental in this effort is my use of the IMF‟s New Database of Financial

Reforms,92 which evaluates 91 economies over the 1973-2005 period along seven dimensions of financial sector policy: credit controls and excessively high reserve requirements, controls, entry barriers, state ownership in the banking sector, capital account restrictions, prudential regulations and supervision of the banking sector, and securities market policy. Use of this database will allow me to approximate „accretion of reform‟ by aggregating successful increments of reform and testing how increases in the index affect the likelihood of successful inflation stabilization. Another set of indexes of reform that I will use to construct an alternative accretion of reform variable is the Morley et al indexes of structural reform in Latin America.93

While the IMF database focuses on financial reform measurements in a large number of countries, the Morley indexes quantify reform efforts in 17 countries for the 1970-1995 period.

This set of indexes quantifies reform effort in five areas: trade reform, financial liberalization, tax reform, liberalization of external capital transactions, and privatization. While both datasets I have described will be valuable in formulating my accretion of reform variable, they are quite distinct in what they analyze, and thus are better-suited to be two separate variables, both of which can be tested in a similar manner. Finally, I include a reform index constructed by

92 Abiad, A., E. Detragiache, et al. (2010). "A new database of financial reforms." IMF Staff Papers 57(2): 281(222). 93 Morley, S. A., R. Machado, et al. (1999). Indexes of Structural Reform in Latin America, ECLAC Economic Development Divison.

63 Eduardo Lora which addresses reform efforts in trade policy, tax policy, financial policy, privatization, and labor legislation.94

By combining this data on inflation, big falls in inflation, sustained falls in inflation, and the levels of reform indexes, I can test my theory that higher levels of reform greatly enhance the chances of successfully implementing an inflation stabilization program. I then include two additional variables in my tests: annual GDP growth per capita (World Bank)95 and a measure of government fractionalization (Database of Political Institutions).96 Government fractionalization, defined as the probability that two deputies picked at random from among the government parties will be of different parties, is included because differences in government power dynamics can have a dramatic effect on being able to develop, pass, and implement successful stabilization programs. I go about testing this theory via two statistical models: survival analysis in Stata as well as a logit regression model.

The motivation behind performing survival analysis using a Cox model in this quantitative test of my theory is that this model tests what the probability of failure is – in this case, failure is actually successful inflation stabilization – given that such a failure has not yet been observed. I am able to use successful and sustained inflation stabilization as my dependent variable, and I run the Cox model using each of the reform indexes separately. By doing this, I see the impact of the reform indexes on the increase in the hazard rate of failure (remember, failure here is successful inflation stabilization). I then take the coefficients from the Cox model

94 Lora, E. (1997). A Decade of Structural Reforms in Latin America: What has been Reformed and How to Measure It. Inter-American Development Bank Working Paper Green Series #348. 95 Bank, W. (1980-Present). The World Bank Open Data. 96 Beck, T., G. Clarke, et al. (2001). "New Tools in Comparative Political Economy: The Database of Political Institutions." The World Bank Economic Review 15(1): 165-176.

64 tests and use a standard formula to translate them into percent changes on the likelihood of failure.97

By running the logit models, regressing „big fall‟ on each of the reform indexes separately, I get a different glimpse of the effect of the reform index measures on big falls in inflation. I see how much higher reform scores contribute to big falls in inflation more generally rather than how they contribute to the discrete events analyzed in the survival analysis. In addition to running the logit models with reform indexes as the only independent variables, I also run logit models using country fixed effects. These country fixed effects account for some of the variation across countries that might be confounding with the reform indexes and/or a country‟s propensity for successful reform. Using these two tests together, I get a good picture of how measures of reform contribute to successful inflation stabilization. While I exclude a number of admittedly important control variables, such as GDP per capita, I believe that these tests produce strong results that indicate the validity of my theory across the region.

5.2 The Tests

The survival analysis clearly supports my theory of the importance of a build-up of reform for stabilization program success. As demonstrated in Table 5.2, the Morley and Lora indexes are both statistically significant at the 95% confidence level, and they have a substantial

97 Box-Steffensmeier, J. M. and B. S. Jones (2004). Event History Modeling: A Guide for Social Scientists. New York, Cambridge University Press. Page 60. The formula to translate the to percent changes is as follows: . The way to interpret this figure is that a one-unit change in the reform index results in this %-change in the probability of a big stabilization success. An additional transformation of the coefficients I use is the following formula: , where is the covariate, is the maximum observed value of the index, and is the minimum observed value of the index.

65 effect on failure (which is, in this case, successful and sustained inflation stabilization).98 Using the formula described in footnote 91, I can analyze the increase in the probability of a sustained stabilization success for each of the indexes. Consider the case of the Morley index, for which

, , and . Plugging these into the formula, I can see that a shift from the minimum observed value of the index (in the sample) to the maximum observed value increases the probability of sustained inflation stabilization by 9,303%. The same analysis for the

Lora index suggests a 2,421% increase in the probability of sustained inflation stabilization when moving from the minimum to the maximum observed reform scores.

Table 5.2 Survival Analysis – Cox Model (1) (2) (3) Time until Failure Time until Failure Time until Failure Morley Index 9.142* (2.25) Lora Index 7.140* (1.99) Abiad Index 2.284 (1.62) N 127 93 138 t-statistics in parentheses * p<0.05; ** p<0.01; *** p<0.001

As can be seen in Table 5.3 below, the logit estimations of the effects of the reform scores on there being a big fall in inflation are significant, both statistically and in magnitude.

The sizeable pseudo- measures indicate that the reform indexes themselves have a lot of explanatory power, even while excluding other admittedly important independent variables.

98 Using the formula described in footnote 91, a one-unit change in the Morley index leads to a 933,842% increase in the likelihood of failure (inflation stabilization). This figure is so dramatic, because the index itself is normalized from zero to one, and thus a one-unit change takes the index from a score of zero (absolutely no reform) to a score of one (perfect reform) – neither of which is observed in the data.

66 Table 5.3 Logit Estimations (1) (2) (3) Big Inflation Fall Big Inflation Fall Big Inflation Fall Morley Index 7.390*** (5.02) Lora Index 17.33*** (6.66) Abiad Index 5.977*** (8.55) Constant -5.757*** -8.278*** -2.958*** (-5.44) (-6.55) (-7.24) N 165 165 275 Pseudo- 0.1483 0.3471 0.3087 t-statistics in parentheses * p<0.05; ** p<0.01; *** p<0.001

In order to account for differences among the countries in the sample, which certainly have an impact on their chances for achieving inflation stabilization, I run the same logit regression model as above including country fixed effects. These results are reported below in

Table 5.4. As can be readily observed, the coefficients remain statistically significant at the 99% confidence level and increase in magnitude. This indicates that, controlling for country fixed effects, the reform indexes have even greater explanatory power in observing big falls in inflation, which can also be seen in the higher pseudo- figures in the fixed effects models.

Table 5.4 Logit Estimations with Country Fixed Effects (1) (2) (3) Big Inflation Fall Big Inflation Fall Big Inflation Fall Morley Index 11.01*** (5.04) Lora Index 31.84*** (5.34) Abiad Index 8.038*** (8.28) Constant -8.228*** -12.02*** -2.558*** (-4.77) (-5.10) (-3.48) N 165 165 275 Pseudo- 0.2929 0.5710 0.4373 t-statistics in parentheses

67 * p<0.05; ** p<0.01; *** p<0.001

Coefficients in logistic regressions are not straightforward to interpret, so the most direct way for me to demonstrate the substantive impact of the level of the reform scores on a big fall in inflation is to analyze the marginal effect of the reform score on the probability of observing a big fall in inflation at the minimum and maximum levels of the indexes. Table 5.5 highlights the relevant statistics for each of the reform indexes.

Table 5.5 Index Statistics Observations Mean Standard Minimum Maximum Deviation Morley 176 0.656 0.140 0.394 0.891 Lora 165 0.464 0.110 0.259 0.711 Abiad 286 0.523 0.277 0.048 0.952

As can be seen in Table 5.6 below, the probability of observing a big fall in inflation goes from 2% to 80% as the average country moves from the minimum score observed in this sample for the Morley index to the maximum observed score. Similarly dramatic shifts are clear for both the Lora and Abiad indexes as well. Moving from the minimum to the maximum score in the

Lora index suggests an increase in the probability of observing a big fall in inflation from less than 1% to nearly 100%. The same probabilities change from 3% to 98% when analyzing the

Abiad index. Clearly, accretion of reform, which contributes to higher observed levels in these reform indexes, contributes dramatically to observing a big fall in inflation.

68 Table 5.6 Marginal Effects after Logit of Index Scores at Min and Max Levels

Marginal Effect at Minimum Marginal Effect at Maximum

Morley 0.02 (2%) 0.80 (80%)

Lora 0.001 (0.1%) 0.999 (99.9%)

Abiad 0.03 (3%) 0.98 (98%)

In order to better isolate the effect of reform scores on stabilization success, I run the same tests outlined above including variables for annual GDP growth per capita and government fractionalization. Performing survival analysis (seen in Table 5.7 below) with this specification, the coefficients on both the Morley and Lora indexes increase in magnitude and remain significant. Noteworthy too is the fact that the Abiad index becomes significant under this specification (which it was not in the model excluding GDP growth and fractionalization).

Table 5.7 Survival Analysis Including GDP Growth, Fractionalization Effects (1) (2) (3) Time until Failure Time until Failure Time until Failure GDP Growth 0.134 0.135 0.176 (1.08) (0.91) (0.95) Government 2.453 1.756* 3.148** Fractionalization (1.70) (2.02) (2.69) Morley Index 10.16* (2.41) Lora Index 10.39* (2.12) Abiad Index 4.110** (2.59) N 127 93 138 t-statistics in parentheses * p<0.05; ** p<0.01; *** p<0.001

Next, I run the logit model including GDP growth and government fractionalization. As can be seem in Table 5.8, all three indexes remain highly significant and decrease slightly in magnitude compared to the specification without the additional control variables. The pseudo-

69 measures for these logit models with additional control variables are slightly higher. This indicates that while including these two control variables helps account for seeing a big fall in inflation, they do not have too great of an effect on the models.

Table 5.8 Logit Estimations Including GDP Growth, Fractionalization Effects (1) (2) (3) Big Inflation Fall Big Inflation Fall Big Inflation Fall GDP Growth 0.0602 0.146* 0.0514 (1.42) (2.34) (1.44) Government -0.000122 0.00207 0.000510 Fractionalization (-0.20) (1.95) (0.72) Morley Index 6.848*** (4.53) Lora Index 18.15*** (6.50) Abiad Index 5.733*** (8.14) Constant -5.441*** -8.780*** -2.839*** (-5.04) (-6.47) (-6.91) N 165 165 275 Pseudo- 0.1584 0.3826 0.3155 t-statistics in parentheses * p<0.05; ** p<0.01; *** p<0.001

Next, I run another logit regression including GDP growth and government fractionalization, this time including country fixed effects. The coefficients on the reform scores change very little in magnitude and remain highly significant. The pseudo- figures for the models increase only slightly, indicating that the GDP growth and government fractionalization controls do not account for much more than do country fixed effects.

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Table 5.9 Logit Estimations with Country Fixed Effects Including GDP Growth, Fractionalization Effects (1) (2) (3) Big Inflation Fall Big Inflation Fall Big Inflation Fall GDP Growth 0.0534 0.180* 0.0445 (1.05) (2.09) (1.08) Government 0.000323 0.000458 0.000556 Fractionalization (0.38) (0.33) (0.65) Morley Index 10.17*** (4.50) Lora Index 32.81*** (5.14) Abiad Index 7.743*** (7.82) Constant -7.493*** -11.97*** -2.276*** (-4.15) (-4.87) (-2.94) N 165 165 275 Pseudo- 0.2998 0.5915 0.4418 t-statistics in parentheses * p<0.05; ** p<0.01; *** p<0.001

Finally, I do the marginal analysis of the probability of observing a big fall in inflation as the average country moves from the minimum observed score in the sample for each index separately to the maximum observed score. There is very little change from the same marginal analysis performed above (excluding GDP growth and government fractionalization), and these results can be seen in Table 5.10 below.

Table 5.10 Marginal Effects after Logit (Incl. GDP Growth, Fractionalization Effects) of Index Scores at Min and Max Levels

Marginal Effect at Minimum Marginal Effect at Maximum

Morley 0.02 (2%) 0.77 (77%)

Lora 0.001 (0.1%) 0.999 (99.9%)

Abiad 0.03 (3%) 0.97 (97%)

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CHAPTER 6 CONCLUDING REMARKS

72 Economic crises and their solutions have long been an area of scholarly interest. The periods of chronic high inflation and bouts of and across Latin American have received a great deal of attention both for their magnitudes and their persistence. Brazil alone implemented a half-dozen failed stabilization programs since the transition to democracy in 1985 before the Plano Real was finally able to tame the country‟s runaway inflation in 1994.

After decades of chronic high inflation, it took yet another decade to successfully address and the problems behind the phenomena (and many of the structural issues in Brazil are still being addressed today). After observing the number of failed plans and the substantial amount of time it took for the nascent Brazilian democracy to successfully tame inflation, I became curious as to what fundamentally changed after all those attempts that allowed to Plano Real to succeed (when even Cardoso himself was not certain it would work indefinitely).

Certainly, many scholars have studied and written about what leads to stabilization and reform program success or failure. Alesina and Drazen call attention to the idea of a war of attrition in society. Others highlight political fragmentation and the strength of labor, among a number of other theories. While I concede that all of these factors have a role to play in successful stabilization and reform, it is my position that the idea of accretion of reform – through mechanisms I discuss including political learning, breaking the social status quo in society, and altering the initial conditions of the economy prior to program implementation – is one that has managed to escape much academic study. It is necessary to analyze how previous program failures altered the Brazilian system in crucial ways that set the stage for the Plano

Real’s success. Most scholars fail to recognize Brazil‟s failed stabilization and reform programs in this light, and this is where my theory departs from the existing body of work. In understanding how past failures altered the status quo, we can more comprehensively understand

73 how the Plano Real was finally able to successfully tame inflation. In testing my accretion of reform hypothesis, I have taken two distinct and mutually-reinforcing approaches.

First, I demonstrate the importance of previous reforms that managed to stick despite being grouped in implementation with other failed measures using a qualitative case study of

Brazil. We see numerous instances of substantive changes in Brazil after failed stabilization and reform attempts since 1985, all of which shaped the policy environment in such a way as to make it possible for the Plano Real to succeed. Brazilian politicians learned from past mistakes.

Cardoso was in a very different position in designing the Plano Real than his predecessors had been, with the acquired knowledge that secrecy did not work, that it was difficult but necessary to force societal and Congressional debate over the reform package, and that the Brazilian people would no longer trust in the efficacy of a heterodox shock. Different actors in Brazilian society were strengthened by the maturing democracy, and others were weakened by Brazil‟s gradual trade opening. The importance of structural factors, especially reserve levels and government budget deficits, were widely appreciated. These factors made Brazil in 1993/94 a dramatically different country than it was during the rebirth of democracy in 1985. These same factors allowed Fernando Henrique Cardoso to do what no policy-maker had been able to accomplish: he successfully tamed Brazilian inflation for the long haul and embarked on a grueling, long- term reform program.

After finding evidence for my theory in the case of Brazil, I turn to analyze its relevance for a wider sample of Latin American countries. I test for the significance of reform as an explanatory factor behind big, sustained falls in inflation. Using both survival analysis and logit models I find that reform indexes have a great deal of explanatory power and are thus necessary to consider when studying factors contributing to economic stabilization and reform. Moving

74 from the minimum observed reform index score to the maximum score suggests and impossible to ignore increase in the chances of failure (failure being successful inflation stabilization in my model) according to survival analysis. The same move from minimum score to maximum score also contributes dramatically to the chances of observing a big fall in inflation according to the logit regression models with country fixed effects. These results support the conclusion that the importance of accretion of reform is key not only for Brazil, but also for the other Latin

American countries tested. Ultimately, although prior attempts at stabilization and reform clearly failed, those efforts were crucial in pushing reform forward slowly but surely, enabling future attempts to succeed.

This theory does not discount the importance of the factors considered crucial by the other theories discussed herein. Rather, I look at how Brazil‟s dynamic experiences with stabilization and reform programs since 1985 affected a number of these factors (e.g. breaking the social deadlock in society, altering initial conditions like reserve levels and government budget deficits, etc.) through the accretion of incremental bits of reform. Even failed programs do not occur in a vacuum, and their effects can be felt throughout the Brazilian economy, government, and society. Ultimately, it is largely these enduring bits of change, the accretion of reform, which set the stage for the success of the Plano Real.

This research on inflation stabilization program success and failure is ripe for extension in three distinct directions. In the first direction, it would be interesting to conduct a similar analysis as I did in my case study of Brazil to countries currently battling with rampant inflation

(e.g. Zimbabwe). By analyzing the path of accretion of reform in countries currently battling inflation, it may be possible to highlight valuable policy paths that would allow the country to vanquish high inflation once and for all.

75 A second direction of research extension would be to extend the analysis of accretion of reform to look at its effects on other phenomena (aside from inflation stabilization). Looking at how the accretion of reform affects development statistics more generally would be an enlightening endeavor. A highly relevant issue in this vein of research would be considering the direction of causality, though. It is not clear to me at this point how one would go about definitively stating a causal link from reform scores to such development indicators, and not vice versa.

Finally, it would be very interesting to find (or possibly, by necessity, create) indicators of reform in more subjective areas, such as education and health. Observing how progress along these dimensions contributes to economic stabilization and reform would be very interesting.

This research would be of great value to the current body of work on international development through its contribution to the understanding of the link between health/education/etc. and economic stabilization, reform, and development. Spending decisions are difficult in international development, so evidence that highlights the value of specific spending areas (like programs in health and education) on not only their subject matters but also on the economy in general, will help bolster decision-making.

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