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Brazil‟S Battle with Inflation Lauren Gramza Mathematical Methods in the Social Science

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Failure as a Precondition for Success? Brazil‟s Battle with Inflation 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 Plano Real, 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. 2 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 3 LIST OF TABLES 1.1 Monthly Inflation in Brazil …………………………………………………………………..7 4.1 Plano Cruzado Measures ……………………………………………………………………35 4.2 Plano Verão Measures ………………………………………………………………………42 4.3 Plano Collor 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 4 CHAPTER 1 INTRODUCTION 5 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 Brazilian real, the newest of six currencies 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 currency, 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 economic history 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
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