The end of ISI and inflation

Brazil's expansion was debt-led, with foreign liabilities largely issued in dollar-denominated assets. ISI created pressures on the balance of payments, as the irony of import substitution was an initial surge of imports of intermediate capital to fabricate the finished product.

Engineer and self-taught economist Mario Henrique Simonsen (1935—97) helped preside over the robust growth engineered by successive military governments by marrying market commitments with statist intervention (Schroy, 2013). Two of Simonsen's most important contributions to economics were a cash-in-advance model of the demand for money, and the novel concept of inertial inflation. Both were at least partly linked to the experience of the Brazilian economy. Inertial inflation referred to the “feedback element” of the inflationary process, as opposed to other more conventional autonomous components such as supply shocks or excess demand. Inertial inflation could be generated by adaptive expectations, indexation processes, or as developed by Simonsen, a reduction in the inflation adjustment interval as price changes gathered pace.

Simonsen broke inflation down into three components: autonomous (picking up exogenous shocks), demand (including government policy), and a feedback variable where past inflation fueled current rates (Cabello, 2013). Simonsen cast Brazilian inflation dynamics in a structuralist light. Rather than simple rational expectations approaches to inflation, he observed that various parties — government, labor and industry — began acting in an uncoordinated fashion to raise interest rates, wages, and prices in anticipation of inflation.

Simonsen also applied game theory models to the wage/income indexation processes at work in inertial inflation. He appreciated the cash-in-advance microeconomic model which posited that money was demanded because it was the only means of purchasing some goods. The paradox in high inflation economies like Brazil was that holding cash was a guaranteed means of losing wealth. The wealthy therefore kept their money in interest bearing “overnight” checking accounts, whereas the poor lost purchasing power due to lack of access to banks.

The high Brazilian comfort-level with theoretical contradictions, such as Simonsen's “monetarist-structuralist” approach to inflation, allowed some conservative economists to ally with nationalists in the military government, to expand the role of the state in defending free market ideology. Unfortunately, the tensions within the mixed model turned out to be too great when hit with external shocks in the 1970s and 1980s. To counter the predictable problems with the balance of payments from an import bias, the government only auctioned the strong cruzeiro currency to the industries deemed strategically important. Not surprisingly, this led to problems with dual exchange rates and prompted hard currency shortages to support the overvalued rate.

In the early 1980s, conditions closed off opportunities for further industrialization using ISI tools. In response to rising inflation in the United States, Federal Reserve chair Paul Volcker pursued a contractionary policy that reined in the global oversupply of dollars.

Inflation was the dominant concern in the lost decade of the 1980s and the first part of the 1990s. At times, Brazil attempted to combat rapidly rising prices by orthodox means, cut­ting the money supply and raising the interest rate to reduce circulating currency; but these attempts failed as inertial inflation had become ingrained in Brazilian institutions. Key interests were protected by an intricate web of indexing. As Albert Fishlow describes, over a hundred laws circumscribed the process of managing inflation in Brazil (Fishlow, 1974). Wages, rents, bus fares, and electricity were adjusted monthly to inflation. Checking accounts were protected by interest paid to pace inflation; no one with access to banks held cash. Private retailers joined the indexation game by printing daily tabelas corresponding to changing prices. Clothing was not tagged by price but rather coded to match the latest rise in the price table. Oligopolistic conglomerates passed on price increases to consumers. Taxes, too, were indexed, albeit at a slower rate. But the poor suffered the most, as informal sector wages were not indexed and those living in crowded favelas rarely were banked. Each pay period was marked by fraught lines in stores as people obtained all the staple goods they could buy before prices increased.

The newly elected democratic government tried to slow this inertial inflation by lagging the pace of indexing behind actual inflation. People came to distrust the government-published inflation indices, clamoring for higher wages to cover rising consumer costs — a spiral passed on at the checkout counter. Investors also began to read interest rate changes as harbingers of future inflation. Rather than observe rising interest rates as evidence of credible contractionary monetary policy, investors interpreted these as signals that the government expected higher future inflation. Those with the capability to invest abroad began to diversify portfolios, choosing to purchase safe assets overseas.

There were many economic plans to tackle the unintended consequences of living with inflation. After failed trips to the IMF in the early 1980s and paralleling the transition from military rule to civilian democracy, Jose Sarney implemented the cruzado plan in 1986 to shock Brazilians out of their addiction to inflation. Wages and prices were frozen; he deputized Brazilians asfiscais, empowering them to arrest store managers who violated the price freeze. Sarney reformed the weak cruzeiro by slashing three zeros off and renaming it the cruzado. These heterodox measures were accompanied by a contractionary monetary policy (Roett, 2011, 88).

At first, Sarney's plan worked; inflation stopped, albeit temporarily. People were encouraged by the new buying power of the cruzado — and made postponed purchases from hyperinflationary times. As domestic consumption spilled into imports, the current account deficit bulged and foreign reserves weakened. Investors reasoned if the government had devalued before, then it could do it again, and so moved money offshore. Expecting the collapse of the cruzado, those with commodities that wouldn't perish hoarded them. As cattle were not slaughtered, meat shortages erupted. These measures were further strained by the new demands of the emerging democratic state.

New hope for political and economic change came with the 1990 election of Fernando Collor de Mello. Committed to clean government and slaying the tiger of inflation with a single bullet, Collor enacted a mega-liquidity shock to wrest inflation from the Brazilian economy by freezing all bank accounts in excess of $1,000. Consistent with orthodox monetary theory, a sharp and credible cut in the quantity of money in circulation rapidly squeezed inflation out of Brazil. The architect of this radical Collor plan was University of Sao Paulo Professor Zelia Cardoso de Mello (b. 1953) (Zelia Mello: Executive Profile and Biography, 2013). Enacted on Collor's first day in office, the plan also engaged aggressive liberalization and privatization in the economy. The problem was in restarting growth. Investment craves capital; Brazilians learned to work around the financial restrictions and money flowed back into the market. Credibility destroyed, inflation crashed back. With a government weakened by corruption scandals, tarnished Collor left the presidency two years after assuming office.

Once again a Vice President found himself in charge. Itamar Franco, a seasoned politician from the powerful state of Minas Gerais, assumed office amidst yet another crisis. Breaking ranks with the market-driven policies of Collor, he saw a more nuanced role for the state in development. He called upon Fernando Henrique Cardoso (or FHC, b. 1931), his finance minister and successor as president, to introduce a quintessentially Brazilian package — a bit orthodox, a dash of heterodox, targeted toward the uniquely Brazilian environment. FHC had begun as a typical dependency theorist, but had become increasingly critical of the sim­plistic leftist interpretation of the idea of dependency that applied rigid Marxist “ruling class” terms. Moving to a more Weberian understanding of class, he distinguished between the different contexts of individual underdeveloped countries, and allowed for more positive aspects to the capitalist “modernization” of the periphery, rather than simple dependency on the center.

In some daring policy engineering, a group composed of FHC, together with the Berkeley economist and former Minister of Finance Pedro Sampaio Malan (b. 1943) and Harvard-trained Gustavo Franco (b. 1956), invented a new unit of account, the urv or unit of real value. This was envisaged as a super index — the big index to out-index all of the indexation that was contributing to inertial inflation. While providing a key function of a currency — a stable unit of value — it wasn't a currency, simply a denominator. After an adjustment to cover declining purchasing power, all other indexes were disbanded. As people began to trust in this unit of measure, a new currency called the real was launched. After over a decade of straining under inflationary pressures, Brazilians swallowed hard budget cuts and the successful new currency propelled Cardoso into the presidency. A great big adjustment had managed to gain control of Brazilao.