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Brazil Fiscal Deficits and Inflation

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Brazil Fiscal Deficits and Inflation

The root of Brazilian inflation has been the monetization of the public sector's fiscal deficit, because deficits that are not financed by borrowing either from abroad or domestically must be covered by the creation of money. By the early 1990s, the old debate between the monetarists (see Glossary), who emphasized the central role of money supply growth in the inflationary process, and the structuralists (see Glossary), who attributed price increases to supply problems in developing economies like Brazil's, was viewed as an obsolete and largely sterile discussion. Instead, debate focused on the causal relationship between inflation and the money supply, and on how much freedom the government actually had in determining money-supply growth.

However important monetization of the public sector's fiscal deficit may have been in the past in either initiating or accelerating inflation, the reinforcement of the inflationary process by past inflation and by expectations of future inflation was an important part of the Brazilian experience in the 1980s and 1990s. In Brazil the feedback effect of past inflation has been institutionalized in an extensive indexation or "monetary correction" (correção monetária ) system, which was developed and extended to most markets between 1964 and 1970. The result was an economy in which apparently modest initial shocks could be transformed into high and continuing inflation. Recognition of this feedback effect in the early 1980s played a role in the design of the 1986 Cruzado Plan, as well as in subsequent stabilization attempts, notably the Real Plan in 1994. The inflation indexation system, which in the 1970s had been virtually unquestioned, was increasingly blamed for contributing to the continuation and acceleration of inflation in the 1980s and early 1990s.

Although inflation accelerated significantly in the 1980s, it had long been a feature of Brazil's economy. The first major inflationary surge began in the late 1950s and continued until 1964, in part the result of the monetary accommodation of fiscal pressures resulting from a sharp rise in government expenditures. A second surge began in the 1970s, partly as a result of the external shocks caused by the rise in energy prices. The indexation system served as a vehicle for amplifying energy price increases into higher widespread price increases than might have occurred. Inflation worsened dramatically in the 1980s, however, as Brazil lost its access to foreign capital markets and domestic borrowing to finance the growing public-sector deficit became increasingly expensive (see table 15, Appendix). Inevitably, money creation became one of the primary ways to finance the deficit.

It is difficult for non-Brazilians to grasp the significance of double-digit inflation for forty years, with triple- and even quadruple-digit inflation in the 1980s. By the late 1980s, annual rates of inflation were almost meaningless, and Brazilians themselves routinely characterized inflation by its monthly rate, which in the early 1990s was over 35 percent. Between the end of World War II and Brazil's Real Plan in 1994, the price level had increased more than 100 billion times.

Not only did inflation accelerate over the 1980s, but the rate became more variable and less predictable. The frequency of price adjustments increased, and wage and salary adjustments that had once occurred annually were adjusted semiannually, then quarterly, and in some markets monthly, as inflation accelerated. In other markets, especially the capital markets, inflation had similar effects in shortening contract periods. Few borrowers or lenders would dare to make long-term commitments, and by the late 1980s most Brazilian firms, as well as most wealthier individuals, held any excess assets in short-term, highly liquid deposits that were literally known as the "overnight."

The rise in indexation in Brazil after 1964 had permitted the government to tap the supply of domestic saving by selling indexed government bonds to savers, who were thus protected against the effects of inflation on the value of such assets. Although indexed bonds were regarded as a great success in the 1960s and 1970s, the need to pay not only the interest but also the inflation adjustment became an increasing burden for the government in the 1980s.

Despite the burden that indexed bonds placed on government finances as inflation accelerated, inflation itself appears to have been an important source of revenue for the government. The "inflation tax," which is the real income that the government receives through the issuance of new money, tends to increase with inflation, because nonindexed money or partially indexed financial assets issued by the government lose their real value. This loss in spending power incurred by the holders of money is in effect a tax, because the government spending financed by money creation is paid for by the loss in value of the money held by the public. Attempts have been made to measure the income that the Brazilian government earned through the inflation tax, and some estimates suggest that income from this source in the 1980s was over 3 or 4 percent of GDP.

Data as of April 1997






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