Brazil May Be About to Give Up its Financial Sovereingty

These are strange times. For those who have been drowning in the craziness milk-shake that is the United States presidential campaign and have not been able to follow other world events (we do not blame you), it should come with some assurance to know that the rest of the world is not doing much better. Case and point is that the acting president of Brasil, Michel Temer, who came to power for being the VP of impeached president Dilma Rousseff, is trying to make Brazil the least financially autonomous nation in the world.

Temer and his cabinet, who have been working towards the implementation of austerity measures in Brazil since they came to power, have proposed a constitutional amendment that will severely limit Brazil’s flexibility in government spending. It would be the 93rd amendment to Brazil’s ‘young’ 1988 constitution. In short, the Constitutional Amendment Proposal 241* (PEC 241 in Portuguese), would create an artificial limit to government spending, which would become pegged to the previous year’s inflation.

The Brazilian economy is facing a dire recession even though the Bovespa stock index and real currency BRBY rank among the world’s best-performing assets this year. The pressure towards austerity is coming from both internal and external players, and the financial markets have rallied well to the prognostic of the amendment’s approval. Despite its failure to produce meaningfully positive results elsewhere, austerity is still seen positively by international financial markets.   

The amendment makes Brazilian fiscal policy hostage to inflation, thus inverting the hierarchy of economic policy in the country; instead of using of its taxes and spending to control inflation, inflation would control Brazilian economic policy. On one hand it makes the job of lawmakers and policymakers a lot easier, on another it takes away powers granted by the constitution to the Brazilian congress and it is, as put by Brazil’s Attorney General, unconstitutional.

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The amendment has been approved by a special commission in Brazil’s lower house on the 6th, and four days later was approved by the lower house as a whole. It comes as a victory to Temer’s austere aspirations for austerity measures had been failing to be implemented in Brazil even during the final days of the previous government. Temer’s own efforts had been facing serious challenges until now.

It is not to say that it all good sailing weather for PRC 241. Portions of the public have come out against the measure. Notably, economists have argued that the debt problem in Brazil is caused by a fall in tax revenue and not because of overspending. Indeed, the high unemployment rates combined with high inflation – among other factors – have caused a real decline in revenue of 2.5%. Meanwhile small business owners in retail have experienced decreases of as high as 30% to their revenue streams.

For those versed in Functional Finance and Modern Monetary Theory this will seem as completely nonsensical. Brazil, currently, is a financially sovereign nation to a good extent. It prints its own currency and taxes on that currency. It, however, has emitted debt in foreign currency, namely the dollar. The amendment would limit this sovereignty, making the Brazilian economy work only within the limits set by the (interior and exterior) factors that affect inflation.

If you have followed our posts for a while, you have read some strong arguments on why austerity is not the remedy for countries facing as recession and that smart fiscal stimulus is much more likely to succeed.

*Some of the sources for this article are in Portuguese.

*This post was written by Carlos Maciel

Italy is Hungry for Expansionary Fiscal Policy

In a meeting with Angela Merkel and Francois Hollande on August 22, the Italian Prime Minister Matteo Renzi proudly announced that Italy has the lowest public deficit of the last 10 years, and will continue with structural reforms to reduce it further. Monti has long aimed to “restore credibility” by cutting the public deficit, and now the Finance Minister Pier Carlo Padoan enjoys praise on his achievement of a deficit as small as 2.4% of GDP. The FED (Financial and Economic Document) goes so far as say this makes Italy “among the most virtuous countries in the Eurozone.”

A closer look at Italy’s economy, however, shows this “virtuosity” has no basis in reality. In 2015, 1.5 million households lived in absolute poverty. Another 4.5 million individuals saw stagnant incomes. The situation has not been this bad since 2005. In addition, the Migrantes foundation informs us that there has been a boom of italians who go abroad, 107,000 in 2015 (+6,2%). Especially youth from 18 to 34 years old (36,7%).
Source: [Ansa.it “Rapporto fondazione Migrantes”]

The percentage of serious material deprivation index is 11,5% for total households members. Official unemployment rate is at 11,9% whereas the real unemployment rate is well above the 20%. The inactivity rate is at 36,0 % and the fixed capital investment ratio is stuck well below the pre-crises (2007-08) levels.
Source: [“Rapporto annuale Istat, 2016”]

It is clear that Italy is stuck in a deep depression. And it’s not alone. Many other euro countries are suffering the same fate. Cutting public spending cannot help them recover. We turn to Keynes to see why it cannot, and consult the work of Minsky and Wynne Godley to see what can.

Keynes and Aggregate Demand

In The General Theory, J.M. Keynes explains the challenges blocking achieving and maintaining full employment in a market economy. He argues that the booms and busts associated with capitalism make this state of equilibrium very difficult to reach. When a bust occurs, and businesses expect their profits to fall, there’s no reason to expect a magical market-force to step in and fix employment while costs are being cut.

This applies to Italy, too. After years of austerity and a Global Financial Crises, aggregate demand levels have declined sharply most people feel uncertain about the future. Additional demand for labor is close to zero and the private sector is pessimistic. Investment and spending is not sufficient to employ the unemployed. Cutting down government expenditure is not going to to help. It will simply make it worse.

Minsky and Fiscal Policy

A follower of Keynes, Hyman Minsky explained how any analysis of a monetary capitalist economy must start from the analysis of balance sheets and its relative financial interrelations ‘measured’ in of cash flows. If balance sheets and especially the relative financial relations are not taken into account within an analysis of an essentially financial and monetary economy, that analysis fails to reflect the full reality.

Minsky’s alternative analysis shows that in case of crisis, a nation needs a “Big Government” (The Treasury Department) and a “Big Bank” (The Central Bank) to step up. These institutions must focus on serving as an “Employer of Last Resort” and a “Lender of Last Resort”, respectively. This way, they can prevent wages and asset prices from dropping further, and tame the market economy. In the Euro-zone, this has not been realized. The Treasury Department is constrained, leaving them unable to reach full employment. Meanwhile, citizens continue suffer under austerity.

Wynne Godley and the Government Budget

Wynne Godley’s sectoral balance approach sheds more light on this Minskyian alternative. He shows the economy consists of two sectors: The government sector, and the private sector (all households and businesses).** The private sector can accumulate net financial assets only if the other sector, government, runs a budget deficit. That is, only if the flows of the government spends more than it receives in taxes. It is impossible for both sectors to run a surplus at the same time.

And as a simple matter of macro-accounting, for aggregate output to be sold, total spending must equal the total income generated in the production process. So given households’ decisions to consume and given firms’ decisions to invest, there will be involuntarily idle labour for sale with no buyers at current wages, if the government deficit spending is too small to accommodate the net desire to save of the private sector.

What Renzi and Padoan are Really Saying

We can now see what Renzi and Padoan are really congratulating themselves for. Having done nothing to lift a struggling private sector out of the recession, they patting themselves on the back for worsening it’s social and economic situation. Renzi may claim he will go to Brussels to “sbattere i pugni sul tavolo”, but his executives continue to respect the Stability and Growth pact regime, and decrease the deficit further.

From Wynne Godley, we know that further decreasing the government deficit corresponds to further deterioration the private sector surplus. So when the officials say they “need to put public accounts in order,” they are actually saying they will put households and business accounts in dis-order. So when they say that Italy has the lowest budget deficit of the last 10 years, they are actually stating that the government is draining more financial assets from the private sector than it has in a decade.

When they call Italy virtuous for keeping a smallest deficit, they assign virtue to the nation that most effectively perpetuates poverty and social disarray. When Renzi says that his non elected executive “will continue […] the reduction of the deficit for our children and grandchildren”, he is instead telling us that his government is going to reduce the net desire to save of the current population, to keep involuntary unemployment and part-time working levels high and to firmly deteriorate the (net) financial and real wealth of the future generations.

Unless Italy changes its approach and adopts expansionary fiscal policy, it will not serve the well-being of the society and its economy. The main goal of full employment will never be attained and maintained. Work will lack moral and economic dignity, public sector goods will fall short in quantity and quality, and basic human rights will be violated. Not only will policy goals fail to be achieved, they will be even farther out of reach. One thing is certain: either Renzi and his ministers don’t know what they’re doing, or they are doing it in bad faith. I am afraid of it may be both.


* To be as precise as possible, Italian public budget deficit has been systematically reduced from 1991, that is the year when the Treaty of Maastricht was ratified which, among other things, established the respect of the parameter of the 3% to the public deficit and 60% to the (flawed) public debt/gdp ratio.
** I do not take into account the foreign sector balance sheet, because the substance of my brief argument won’t be undermined.

The Brazilian Burden

On August 29th Dilma Rousseff, the democratically elected Brazilian ex-president, defended herself at the Senate against accusations of fiscal fraud, the so called “pedaladas fiscais.” Despite her defense, two days later, the president was formally impeached, putting an end to a process that has been carried on since May, when she first left  office to face trial. The crime accusations were mainly accompanied by harsh criticisms of how the Workers’ Party (Partido dos Trabalhadores, PT) fiscal irresponsibility led to the poor economic condition that the country finds itself. Among the economic meltdown and several scandals of corruption, her approval rate  and the popularity of her party collapsed in recent years. After 13 years of the leftist PT administration, the presidency is now occupied by the then vice-president Michel Temer, member of the centrist Brazilian Democratic Movement Party (Partido do Movimento Democrático Brasileiro, PMDB), a party also involved in corruption scandals, and whose popularity is as bad as his predecessor.

Political matters “apart,” the Brazilian economic situation is indeed dire. GDP is expected to contract 3.18% in 2016, a second year of contraction, following the 3.85% in 2015. Unemployment increased more than four percentage points from the beginning of last year, reaching 11.3% in June 2016. Despite the poor economic performance, inflation is still above the 6.5% target roof, being expected to accumulate 7.4% this year. The inflationary pressure comes mainly as an effect of the rapid exchange rate nominal devaluation of almost 54% within the years of 2015 and 2016, reaching now R$ 3.29 per dollar. As an attempt to control inflation and attract foreign capital, the Brazilian Central Bank – going in the opposite direction of the major Central Banks – sharply rose the short-term interest rate (Selic), sustaining it at 14.25% (!!!) since mid-2015. This also had a feedback effect on the government’s total deficit. (*)

Two questions remain open: what are the real roots of the economic crisis and will the new administration be able to tackle it? To understand the roots of the bust, it might be easier to refer to the very causes of the boom that preceded it.

The boom and bust

From 2002 to 2008, the Brazilian economy performed really well, growing at an average of 4% per year. This was possible mainly by a combination of policies aimed to reduce poverty and income inequality along with the positive international scenario.

Increasing worker’s real wages and government cash transfers to poor households – channeled mainly through social security and the famous Bolsa Família – established a virtuous cycle of increasing private consumption. Another important factor was the promotion of policies towards labor-market formalization, which guaranteed not only access to social security but also the availability of poor households to private lines of credit. Note, however, that not only poor households benefited from “cash transfers”: the historically high short-term interest rate guaranteed that rich households too enjoyed the fruits of the boom. The government managed to attend then both extremes of the income distribution.

brazil3-sizedInternational conditions also played a major role in boosting the domestic economy. High international liquidity and the commodity-price super cycle guaranteed appreciation of the exchange rate, which beyond positively impacting domestic real wages, also helped to keep inflationary pressures under control by making foreign goods more accessible.

The Brazilian economy suffered its first hit with the 2008 financial crisis. Despite the GDP growth of 7.5% already in 2010, the fast economic recovery was mainly a result of aggressive counter-cyclical expansionary policies by the government, who acted through state-controlled enterprises (as the oil and energy companies, Petrobras and Eletrobras) and programs of investment in economic and social infrastructure. From 2011 on, GDP returned to low levels, making it necessary for the government to adopt a new set of policies that can be summarized in tax exemptions and subsidized credit expansion to private companies from public banks. As it happens, this attempt to increase private investment had the only effect of deteriorating the public fiscal situation.

The budget, the budget!!!

The change in orientation of government policies – from an expansion of public investment in 2008-10 to a provision of fiscal stimulus to private companies in 2012-14 – happened at the same time as the commodity boom ended. Already in 2011, commodity prices stagnated and, along with Brazilian terms of trade, started its downward path in 2014. The end of the commodity cycle had a harsh impact not only in economy’s aggregate demand but also on the fiscal budget.

Before we get to the fiscal issue though, please, don’t get me wrong. The cause of the Brazilian economic crisis is less a result of the end of the commodity boom in itself than by the productive structure that such cycle reinforced. Brazil’s external sector is highly dependent on the exports of primary goods, and this dependence only deepened in the past decade. In 2015, roughly 50% of Brazilian total exports were composed by primary products, a number that increased 4.5% per year since 2002, when it accounted for less than 30%. If we include natural resource-based manufactures on the calculus, it reaches nearly 70% of total exports! Furthermore, while labor productivity increased 5.3% per year from 2000 to 2013 in the agriculture sector, it decreased 0.6% per year in the manufacturing industry.

No wonder when commodity prices reverted trend the economy took a strong hit. Instead of setting the ground for the eventual bust, Brazil placed all its coins on booming commodities. Despite all the public investment programs and fiscal exonerations to the private sector, the PT administration did not manage to increase investment as share of GDP, which remained stagnant around the 18% level throughout 2002-2015 – with public investment accounting for less than 3% of GDP. Lack of investment in infrastructure and manufacturing industry perpetuated an anemic economy with low productivity and dependent on economic cycles.

Public consumption and investment decreased even further after 2014 when the rapid deterioration of the fiscal budget turned the 3%-of-GDP government fiscal surpluses to almost 3%-of-GDP deficits. It is interesting to notice that the decreasing surpluses started in 2011, not accidentally when commodity prices stagnated. We can look at the  three institutional balances for the Brazilian economy, representing the government, private, and foreign sectors, as follows below in order to see these trends more clearly.

 

 

We already know from previous posts on this blog (see here and here) that the government sector has a “crowding-in” effect on the private sector, meaning that government expenditure will, by an account identity, revert in private sector savings. Of course, in an open economy, this is only true as long as we assume the foreign sector to remain “stable”. Both the private and government sectors can only simultaneously run a surplus if the foreign sector generates a surplus that is big enough to account for both. (The intention of the figure presented is not to show that the balances sum to zero – which could be demonstrated by inverting the sign of the private sector and using a bar graph  – but to show the movements of the financial assets and liabilities between the three sectors).

In the case of the Brazilian economy, the improvement of the foreign sector in 2001 allowed an increase in the private sector savings and a decrease in government total deficits. Once the financial crisis struck at the end of 2007, despite the counter-cyclical policies, the deterioration of the current account was mainly absorbed by a decrease in savings of the private sector, with government persisting to run primary surpluses and to sustain its total deficit level – even decreasing it until late 2012. On that year, we observe a sharp deleveraging of the private sector which, given the steady trend of the current account, was completely mirrored by the public sector.

Once again, the mistake – to name one – of the PT administration is that instead of increasing fiscal stimulus through direct government expenditure and investment in infrastructure it bet on providing credit and fiscal exonerations to the private sector as an attempt to increase private investment. In a scenario in which – to use Minsky’s terminology – the demand price of capital decreases at a faster rate than the supply price of capital, investment will not take place. In other words, despite the stimuli reducing the cost of new investment, expectations of profits were falling at a faster rate. In a situation of lack of aggregate demand, the government has to directly spend in order to create the necessary stimulus to the private sector through the generation of profits. Its avoidance led to the deterioration of the fiscal budget through the revenue side, surpassing now 10% of GDP, a result of the economic meltdown.

Instead of stimulating the economic activity by driving aggregate demand and adjusting the economy by sustaining the levels of output and employment, the government opted, mainly after 2014, for a “building confidence” strategy in which it compromises to reducing inflation, generating primary surpluses by increasing interest rates, and cutting government deficits, an adjustment that comes, in such case, through deepening the economic recession. All of it with the intention to attract market’s attention and foreign capital inflows. It, in fact, has a huge potential to generate financial fragility – but this is subject for another post.

And what now?

To address the second question posed at the beginning of this text, it is hard to believe that the new administration will be able to revert the dire scenario. It is still unsure if Temer will have the political leverage to pass important fiscal structural reforms in Congress, such as pension reform. Temer’s pledge to sharply reduce the government deficit can be summarized in the attempt to pass a law that will impose a limit to government expenditure indexed to the inflation level of the previous year. Besides reducing the ability of the government to invest, it also means cutting spending on areas such as education and public health, thus reducing the welfare state that was established in the previous decade, a major element in the virtuous cycle.

Whether or not promising to reduce inflation and the public deficit will be miraculously enough to stimulate agents confidence in the future, it will for sure hurt the economy and lead to a further decrease in demand price of investment in the short-run. In a situation of deleveraging private sector and slow global trade, it is unlikely that private investment will rise anytime soon. Until then, workers will be the ones to suffer from the increasing unemployment levels. The interest rate, beyond undermining any conceivable investment effort that could come from private agents, also carries a feedback effect to government budget and a distributive matter, as mentioned in the beginning of this text. When the pressure to cut government spending increases, “attend both extremes of the income distribution” becomes a hard job. We already know which side was chosen. Unfortunately, very often the adjustment burden comes from the weaker side.

(*) All the data presented in the text are extracted from the Brazilian Central Bank (BCB) and the Brazilian Institute of Geography and Statistics (IBGE).

Why is Austerity Still Being Prescribed?

After years of strict austerity and a worsening crisis, the Greek economy is still in a slump.

However, Eurozone officials continue to prescribe the medicine of austerity.  The diagnosis for the Greek crisis was the fiscal profligacy of its government, and thus to restore the health of its economy, Greece simply had to slash its spending. As with any prescription, some short-term side effects were expected. However, year after year the side effects have gotten worse, with unemployment and poverty at all-time highs and demand at all-time lows. Meanwhile, the economy, in a deepening recession, is far from being cured. To make matters worse, despite the reduced fiscal deficits, the shrinking economy means the debt-to-GDP ratio is nevertheless growing.

In the aftermath of the Global Financial Crisis, Europe embraced austerity as the best medicine to cure its damaged economies. Conservative economists and leading institutions such as the European Central Bank (ECB) and International Monetary Fund (IMF) promoted the concept of austerity. The EU imposed spending cuts on all its members. It is using the dire situation of Greece as a warning against the accumulation of more debt. A  council of Eurozone ministers, spearheaded by Germany, aggressively pushed for more austerity. Meanwhile, despite complying with the prescribed “medicine,” the health of the Greek economy grew increasingly worse…

However, the theoretical justification behind austerity is questionable. The fear of government deficits was backed by studies such as “Growth in a time of debt” by Carmen Reinhart and Kenneth Rogoff. This paper, published in 2010 predicted catastrophic economic consequences for any country surpassing a debt-to-GDP ratio of more than 90%. Backed by this research, high-ranking European officials made their case to abruptly cut government spending.  

While Reinhart and Rogoff’s study created a buzz amongst conservative politicians when it was published. However, it was mostly ignored by the same politicians when it was discredited.  In 2013, it was shown that the spreadsheet used for the calculations in the study was laden with mistakes. Its results were gravely exaggerated. After the errors were fixed, some correlation between government debt and slow growth remained but not one sufficient to establish causation. It is plausible to assume that slow growth is the cause of the increase in government debt. A summary of this controversy can be found.

In the early 2000s, the Greek government began to accumulate massive amounts of debt. By 2009, the government debt had reached almost 135% of GDP. The government quickly enacted extreme spending cuts. So, it is resulting in a  ratio decrease that lasted until 2011. However, the Greek economy, in the midst of a deep recession. It did not respond very well to these cuts which came coupled with the added bonus of tax hikes. Domestic demand collapsed and unemployment soared. Moreover, overall confidence in the economy faded. Greek GDP fell, and the debt-to-GDP ratio exploded. Currently, that ratio is at about 180% of GDP and is projected to reach 200% by 2020. (OECD) The Greek economy is on a downward spiral in which imposed spending cuts reduce incomes, reduce spending, and further contract the economy, and limit its ability to repay its debts.

Despite the academic case for austerity weakening, the Greek parliament is forced to impose even deeper spending cuts to receive more funds from European institutions. Without additional loans, Greece would be unable to make the payments on its previous debt. However, most of the bailout money received by Greece has gone on payments for maturing loans.

The Greek sovereign debt has turned into a ponzi scheme. New loans are obtained to make interest payments on older ones, while the principals rise and the economy shrinks. The IMF, initially a main proponent of austerity, has recently come out in favor of restructuring Greece’s debt and allowing for some economic stimulus. It appears that EU officials are finally willing to listen, at least in respect, to debt restructuring. Last week, the council of Eurozone ministers agreed to discuss some debt relief. However, this comes with the same condition attached: more and even harsher austerity.

For a sick economy such as Greece, it is difficult to see how even aggressive spending cuts could nurse it back to health.  After austerity has failed year after year in reducing Greek debt and revitalizing its economy, it is time to try a different medicine. Under EU agreements, countries are required to be fiscally conservative. Moreover, EU officials, under German direction, have refused to change their stance on weakening the austerity imposed on Greece. Greece’s suffering has become an example of what happens when those rules are broken.

However, if the EU wants Greece to repay its debt and recover, it needs to stop punishing it and give it room for growth. The European officials who continue to force austerity on Greece should take a step back and realize that the best way to reduce the Greek debt-to-GDP ratio and make it sustainable, is to allow for its economy to grow. Clearly, austerity measures have not brought about the desired growth and health. Greece needs a different prescription. One that would indeed stimulate its economy and not keep it locked in an ICU.

Written by Lara Merling
Illustrations by Heske van Doornen