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Taming inflation: learning from Brazil's experience
Caio Megale, The Zimbabwe Independent
May 18, 2007

http://www.tmcnet.com/usubmit/2007/05/18/2637737.htm

ZIMBABWE'S current economic environment bears stark resemblance to the situation in Brazil 20 years ago. At the time, Brazil experienced high levels of inflation significantly above double-digits per year for practically the entire second half of the 20th century.

In the 1960s and 70s, inflation in Brazil was controlled at relatively palatable levels of around 20% per year, and economic growth was significant, financed by a high degree of indebtedness. Brazilians generally accepted this gradual rise in prices because overall economic growth was relatively good.

In fact, inflation was seen as the undesired consequence of economic development. To protect the salaries of workers, the government introduced indexation, whereby wage contracts were adjusted to match inflation. However, after the 1970s, economic growth stalled and inflation skyrocketed from around 300% to 2 000%. At this point inflation became a tremendous problem and economic policy-makers realised they had to tackle the problem.

There are a number of costs of high inflation. High inflation decreases the predictability of economic variables. With no predictability you cannot invest and the potential growth of the country collapses. Inflation is also a powerful income concentration instrument. Real wages are eroded and poor people do not have access to financial protection. In the end,their economic situation worsens under inflation.

Brazil's experience in combating inflation provides us with important lessons. First, we have to bear in mind that any disinflation plan involves important costs, mainly in terms of social wellbeing. Thus, the perception that inflation is a major obstacle to the country's development must be accepted by most of society, and all efforts must be made to overcome this obstacle.

Another important lesson is that one should not succumb to the temptation to carry out social justice during the implementation of a stabilisation plan. The stabilisation plan must be neutral from an income distribution standpoint. Otherwise, stability will bring a distortion of relative prices, and pressure to realign prices will tend to bring the inflationary process back.

The common reaction of authorities is to stabilise prices to protect the population from spiraling costs. In Brazil, each new attempt to stabilise prices was followed by periods (increasingly shorter) of some stability, before inflation returned with even greater vengeance.

Lasting stabilisation was only achieved with the implementation of the Real Plan in 1994. A combination of bold measures, well-grounded on economic theory, with the lessons learned from a series of ill-fated experiments, enabled Brazil to reduce inflation, which, at that moment, exceeded 1 000% per year. Before the 1994 Real Plan, the Brazilian government introduced monetary reform that established a new currency in February 1986. This reform was accompanied by a series of measures such as freezing of prices and salary increments.

Between March and June 1986, inflation came down strongly from over 400% per year to between 10-15% per year. However, two crucial errors were made: for all practical purposes, salaries were not frozen, and the clear signs of excess aggregate demand in the following months were not combated. Bonuses were granted to the lower classes via a 16% hike in the minimum wage, and the dates of the collective labour agreements were reestablished.

In addition, salaries were corrected based on 60% of the accumulated variation of the cost of living in the 12 previous months, and a trigger was implemented to automatically correct salaries whenever accumulated inflation totalled 20%. This currency reform failed, prompting government to introduce other packages in the ensuing years. They all had similar diagnosis and consequences.

One such plan was launched in March 1990 by the economic team of President Fernando Collor, the first president elected by popular vote in Brazil in almost 30 years. Although it failed, the Collor government achieved important steps in the structural reform of the Brazilian economy that were crucial to the success of the Real Plan in later years: it launched the process to privatise state-owned companies and promoted a broad opening of the economy to foreign trade.

Learning from past failures, the Real Plan embarked on a new anti-inflation strategy.

While many past plans started with price and wage freezes that were announced by surprise, the Real Plan did not make use of any direct control of prices or surprise announcements. In fact, the main innovative characteristic of the Real Plan was its transparency following the catchphrase of the economic team at the time of the launch of the plan: "announce only what will be done and do only what was announced". Also key to the plan's success was the role of the Minister of Finance in protecting the economic team from political interference, as political pressure had been the main cause of previous failures.

The first phase of the Real Plan consisted of controlling government spending. The Brazilian leg transfer funds to fulfill the budget. With the fiscal side heading towards equilibrium, the next step was to move towards the full indexation of the economy. The first step was to create a unit of account that would serve as an indexer for all prices in the economy. Dollarisation of the economy thus was prevented because agents did not need to flee to the dollar to protect their assets given the legal mechanism of indexation. The strategy was to create a proto-currency that would work only as a unit of account.

The exchange rate of this proto-currency (called URV, or Real Unit of Value) in relation to the legal currency would be calculated as a function of a basket of general-use price indexes, in accordance with a previously announced formula. The conversion of prices was voluntary and the government concerned itself only with establishing clear rules for the conversion of some services (school tuitions and rents, for example), the prices of public tariffs and wages, which were to be converted from legal currency to URVs based on the real average of the four months prior to the implementation of the plan.

In other words, the need for the plan to be neutral from the distributive point of view was maintained. All of these points were exhaustively presented to the public in a way that there were no surprises to the stakeholders.

Over the first three months that the URV was in effect the public became increasingly used to the new unit of account, even though to settle their purchases they used a currency that lost value on a daily basis. After three months, economic agents were required to display the price of their products in both the legal currency and URVs.

The economy was then full indexed, on July 1, 1994, the old currency ceased to exist and the central bank began to issue a new currency, called the real, which was worth exactly one URV. In that instant inflation fell from 30% per month to less than 20% per year.

What have we learned from Brazil's anti-inflation plan period?

First, society must be keenly aware of the consequences of high inflation. Government, business, and the average person must all agree that inflation is an ill that must be tackled and they all must be prepared for any bumps along that road in order to succeed.

Secondly, do not attempt to carry out social justice programs during an anti-inflation plan. Efforts to increase wages, for instance, will only jeopardise the success of the plan.

Thirdly, taming inflation is not the solution of all problems. It's just one but very important step along the economic recovery path.

Zimbabwe should learn from Brazil.

* Dr Caio Megale is partner and chief economist at Maua Investitmentos, Brazil. He is the 2005 recipient of the Brazil Development Bank Economy Award.

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