Itaú BBA - What Is the Alternative?

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What Is the Alternative?

September 4, 2015

Is the solution to accept a primary deficit? Definitely not.

Brazil is depressed, clinically. The country fails to see a way out of its troubles. The fiscal problem is seen as insoluble. Previous fiscal targets? The country has failed to meet them. Lower targets now? They are no longer feasible. And what about the future targets? No one believes in promises anymore. But what if this time it’s for real, with expenditure cuts? Allegedly, there is no space for that (even though spending stands above 40% of GDP). And increasing taxes, as was done in the past? People won’t accept that any more. Is the solution, then, to passively accept a primary deficit (which leads to a total budget deficit of close to 7% of GDP)? Definitely not. Doing so would be equivalent to choosing higher inflation, deeper recession, lower real wages and worsening income distribution.

To propose a primary deficit (instead of a surplus) for next year’s budget is to implicitly recognize the inability of avoiding the worst path. It means there is no consensus on transforming a current imbalance into a future equilibrium. The result will be increasing public debt. And higher sovereign risk. In this case, the rating agencies would likely downgrade Brazil's investment rating, and investors would reprice Brazilian assets, leading to exchange rate depreciation, stock exchange corrections, and higher market interest rates.

In the absence of other feasible alternatives, inflation is the ultimate solution. The depreciation of the real would translate into higher inflation and lower incomes (in real terms). Wages hardly keep up with accelerating inflation, especially when the labor market is weakening. In this scenario, the poorer lose more, since they are financially more vulnerable and consumption takes up a larger share of their income.

Inflation is a regressive tax that closes the gap by brute force. In the past, it was Brazil’s classical solution. Current leadership in Brazil refuses to opt out of this solution.

But the old solution will face the modern institutions: there are now inflation targets and a central bank with a responsibility to meet them. To avoid higher inflation, economic activity may suffer even more. In the absence of adjustment via prices, the economy may need to further adjust through quantities.

The higher sovereign risk reduces investment, hindering activity and weakening the labor market. This weakness destroys jobs and forces a decline in real wages, the total wage bill and consumption. Then the recession may deepen.

The loss of real income, which disproportionately affects the low-income population, would affect income distribution, and the new middle class would suffer, pushed down to the low-income level – a traumatic backward movement.

The developments described above would be the effective result of choosing not to decide. But what is the actual alternative?

At present, further spending cuts are seen as very difficult. Reducing social security benefits is also seen as unpopular and almost impossible. But increasing inflation, losing investment grade status, deepening the recession and worsening income distribution – is that a viable alternative?

I refuse to believe that a country with so much spending and inefficiency is unable to find room for some improvement. Surely, there are low-hanging fruits to be harvested. The counterargument is that, unlike the harvesting of fruit in the tropics, improving the economy needs organization, leadership and some consensus.

We certainly have problems called "structural" (meaning those that are long-standing and difficult to solve). It is believed that Brazilian society has adopted a major "social contract" since at least the 1988 Constitution, which granted benefits to various groups of people. But these benefits no longer fit inside Brazil’s GDP. The tax burden required to afford this welfare state has already paralyzed the economy. The debt created to finance this increased spending reached a ceiling, and the risk of losing the investment grade rating attests to this.

It is a common belief that one has to take advantage of a crisis to make the tough changes: fear of the worst turns consolidation and reform into the lesser evils. In normal times when facing two difficult choices, one hopes that a more benign third option would eventually materialize. Decisions are thus delayed, waiting for this benign option that never appears. A crisis, on the other hand, forces a decision (provided there is a minimum of organization and leadership).

The choices to be made are certainly hard: revising benefits and adjusting the size of the state to available income. This is far from a trivial task. It is easier to give than take. Or engage in self-deception rather than to accept reality.

But this harsh reality should not be a reason for procrastinating. The tough task needs to be handled right ​​here, right now. The policies adopted today are not neutral: they worsen or improve the structural problems.

Not all is stalled. Some adjustments are underway. The more depreciated exchange rate is already reducing the current account deficit and stimulating export- or import-competing sectors. This is one of the few current sources of growth for the Brazilian economy.

Freeing regulated prices brought relief by removing major distortions and helping the economy. The quasi-fiscal adjustment corrected unsustainable subsidized programs. Investment in infrastructure and the reforms of PIS/Cofins and ICMS unification, if approved, are efforts in the right direction.

But it is essential to solve the fiscal problem if we hope to see stabilization and economic recovery. This will require the implementation, for example, of budget cuts in the short term (and future reforms to limit spending growth in the long term). These cuts could avert a crisis or, in other words, save us from implicitly choosing the worst option. 


Ilan Goldfajn is chief economist and partner of Itaú Unibanco.



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