Brazil Is the New America: How Brazil Offers Upward Mobility in a Collapsing World (29 page)

As the end point approaches, credit markets jam up, a forewarning that the system is stressed and something big is coming. The U.S. economy peaked in 2007. But notwithstanding the fact that the financial system was imploding under the weight of oil prices that approach $150 per barrel, the stock market continued to rally. There was a recurrence of this precrisis environment as 2011 drew to a close. This time, the problem was worse. It was not just a question of subprime American homebuyers finding that they bought more house than they could afford. Entire countries are going bust. The heavily exploited fiction that the sovereign debt of countries in the Organization for Economic Cooperation and Development (OECD) is riskless is being exposed as a fantasy.

“If you've seen one, you've seen them all,” would be an apt description for most of the world's banking and monetary systems. Given that they are all fiat systems with fractional reserve banking, Brazil's is distinguished by some subtle, yet important differences informed by the Brazilian experience with hyperinflation as recently as the mid-1990s. “From 1980 when the IMF price level series began to 1995 the price level in Brazil increased by a factor of 1 trillion. That which cost one real in 1980 cost 1 trillion reals in 1997.”
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Economists at Brazil's largest private bank, Bradesco, looking over a longer period, asserted that accumulated inflation in Brazil between 1961 and 2006 was 14.2 quadrillion percent. That is 14,200,000,000,000 percent—the highest in the world over that 45-year span. Decades of hyperinflation provided Brazil with an expensive tutorial. This led Brazil to realize at least two distinct advantages:

The second achievement is far the more important. The story of how it was done has been told by its architects, one of whom was Gustavo Franco, former governor of Brazil's central bank and a key player in the economic team that struggled for a decade to come up with “a policy that could stabilize the economy.”
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Dr. Franco's account of the obstacles that the reformers overcame includes the intellectual challenge of sorting out the actual cause of the problem. Not surprisingly, perhaps, the hyperinflation itself so thoroughly skewed economic accounting that it obscured cause and effect relationships. Eventually, however, Franco and his colleagues, led by the then-finance minister, and later the thirty-fourth president of Brazil, Fernando Henrique Cardoso, determined that runaway spending was the underlying cause of hyperinflation. Franco said, “The Brazilian state had begun to spend twice as much as its ability to collect taxes. But it was difficult to see this from the numbers. Hyperinflation then produced many funny theories about its causes. It took us 10 years to work through these to an actual solution.”
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To successfully implement a remedy to runaway spending required the reformers to circumvent and defy the special interests that ordinarily dominate consideration of budget questions. Cardoso came to the task well-armed as a professor of political science at the Universidade de São Paulo. In the event, a primary reason Franco cited for the ultimate success of the reformers was the fact that they were able to act during a unique interlude,

[W]here none of the political forces of the country were able to intervene in the process to promote the special interests that the state had been committed to supporting in the preceding decades. Pres. Fernando Collor de Mello was impeached in December 1992 and replaced by his vice president, Itamar Franco.
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Franco recalls the good luck that his namesake, President Franco “was not interested in economics and signed anything the ministers would bring him. This was unbelievable, but it depoliticized the process.”
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Equally, Brazil's Congress was luckily weakened by a major scandal “in which 26 members of Congress and three state governors were implicated in diverting millions in federal funds into their own accounts.” This facilitated needed reforms because it “kept them out of the discussion. This gave us a window of opportunity when the politicians did not interfere.”
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Putting a “politically incorrect” gloss on it, Franco said, “We empowered the treasury and the central bank to subvert democracy.” (For democracy here, read, the unfettered operation of special interest politics.) The problem was that special interest groups and political representatives beholden to them had voted to give themselves things the country could not afford. The reformers answer: “The finance ministry, treasury, and Central Bank, using a constitutional amendment passed in 1994 simply did not implement the budget.”
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They closed off-budget spending while the Treasury exercised de facto line-item vetoes on the congressional budget. “While Congress had passed a budget that authorized, say, 800 million reals for a project, the treasury chose to actually expend only $200 million.”
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Curtailing spending out of an empty treasury was a giant step toward reforming the system. But it was not enough. The reformers also took aim at the banks who had become accomplices in financing runaway spending: “The flood of bad loans from banks to fund the government projects the government itself was no longer underwriting was stopped by imposing criminal penalties.”

As Franco recalls,

[W]e prohibited–made it a crime–for a bank to lend money to one of its own shareholders. Bank officials in the private sector did not even maintain checking accounts in their own banks, for fear of being prosecuted if their check guarantee cards lent them funds to cover an overdraft. But the state banks could lend to the government. Under the Real Plan we enforced the same rules on the state banks and threatened the bank officials with jail if they lent money to the government. We criminalized a major source of inflation, especially where regional banks frequently bought government bonds. We made that illegal.
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As of mid-1994, 40 or more Brazilian banks were actually insolvent because of their lending to government projects: “We began in December 1994 with the intervention in Banespa (Bank of the State of São Paulo) and other state banks. Banespa was the largest state bank in the country with claimed assets of $30 billion—but with real assets of a negative $25 billion.”
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The rate of price inflation in Brazil dropped dramatically after July 1994 in response to the Plano Real. By 1997 price increase rates had subsided to low single digits. The hyperinflation was over. Franco, Cardoso, and colleagues had succeeded through a process that “departed not only from the accepted theories, but also the accepted political process.” As Franco recalled, “The key was to create an impersonal mechanism, not to get into negotiations with parties and unions—or housewives associations. You need market mechanisms. Dialogue doesn't work in this kind of situation.”
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In short, the authors of the Plano Real cut the Gordian knot of political impasse by ignoring and/or sidelining the special interest groups that as a matter of course dominate the corporate state. “The assumption here was that each constituency, if consulted, would fight for its particular entitlement, driving the state budget back up and keeping the price spiral virulent.”
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The paradox is that Brazil has thrived as a deleveraged economy and consequently does not face the quandary of figuring out how to borrow its way to a higher savings rate that perplexes American and British policy makers in the current depression. The deleveraged state of the Brazilian economy is partly an artifact of punishingly high real interest rates in the recent past. As of June 30, 2002, Brazilian government loans yielded 17.7 percent. Business loans yielded an average of 38.28 percent. And the average annual yield to banks on consumer loans was a punishing 60.57 percent. Taking out a consumer loan in Brazil made about as much economic sense as borrowing from a Mafia loan shark.

One of my mentors, the late Mancur Olson, was fond of saying that “values reflect what used to pay.” Or not pay, as the case may be. With the average annual interest rate on consumer loans bumping above 60 percent just a few years ago, it is easy to imagine why Brazilian consumers have tended to shun credit, although that is changing as millions of new consumers attain middle-class incomes.

I believe that the relatively recent history of hyperinflation in Brazil, which ended only in the late 1990s, has acted almost like the mechanism of the gold standard. It has informed incentives for highly conservative banking regulation, along with sound fiscal and monetary policy.

Banking crises have historically spilled into Brazil from abroad—as they did on several occasions near the turn of the millennium. Brazil caught contagions from the “Asian flu” in 1997, the Russian crisis of 1998, and still another contagion from Argentina in 2002. There was also a financial crisis in 1999, when Brazil ended the peg of its currency, the real, to the dollar.

Candido Bracher, president and CEO of Banco Itau, summarized the Brazilian experience: “During the 1990s and various crises—the Asian crisis, Russian crisis, every crisis—Brazil was hit severely. We were so dependent upon foreign savings. Our foreign-exchange rate was devalued very quickly. We had to send our interest rates through the roof to attract capital. In all these cases, if there was a liquidity crisis abroad, we would be very severely hit.”
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With those recent crises in mind, Brazilian bank regulators were alert to the prospect of further crises and bank failures in the offing.

In most countries, banks are obliged to maintain some minimum capital ratios—capital as a percentage of their assets (loans)—as recommended by the Bank for International Settlements in the so-called Basel standards. Rather than establish a simple leverage ratio, however, those standards were fudged with a risk-weighted approach. In practice, this meant that some of what proved to be the biggest and riskiest banks in the world were leveraged to the hilt. Inevitably, supposedly AAA credits, like subprime loans and sovereign debt proved to be far less blue chip than regulators in the advanced economies pretended.

Part of the problem with the risk-weighted approach was that it tended to rest on historic track records that purported to show little or no prospect of sharp downgrades or default in debt instruments. Unfortunately for many international banks, particularly those in the United States and Europe, the Basel standards enshrined the anachronistic fiction that the sovereign debt of OECD countries is riskless.

Other absurdities abound in the Basel standards. For example, ratings agency Moody's “Transition Matrix for Withdrawn Ratings” based on experience between 1920 and 1996, showed only a 0.03 percent chance of an Aaa-rate bond falling after one year to a rating of Baa. This is the perspective that leads gamblers to play Russian roulette. (“The track record shows I haven't blown my head off yet.”) More to the point, it helps explain why AIG sold hundreds of billions of cheap credit-default swaps that devastated that company.

Imagine AIG's amazement when an avalanche of AAA-rated subprime mortgage securities swooned into default.

U.S. banking regulators swallowed the same cocky assumption about systemic risk. They designed banking regulations the way AIG wrote credit-default swaps: on the mistaken faith that there would never be a credit collapse.

In the U.S. banking system, before the subprime crisis, the effective capital ratio was often as low as 4 percent, though it had to be no less than 5 percent to meet the standard for well-capitalized banks owned by bank holding companies—a group that includes the top 20 U.S. banks. Their capital ratios at the onset of the crisis varied between 5 percent and 8 percent.

Although U.S. and British bank regulators played a major role in negotiating the Basel II Accords (initially issued in June 2004 to help protect the world banking system from risks arising from bank failures), they choose to adopt the minimum permissible capital ratios as their regulatory norm. Brazilian bank regulators went the other way entirely. They insisted on limiting the leverage in the banking system to minimize the risks and costs of a future banking crisis.

All Brazilian banks must maintain minimum capital ratios of at least 11 percent. But many Brazilian banks have capital ratios of 16 percent or more—double, or even triple, the levels in the United States and Britain.

There has been a lot of jabber in political circles about the Great Correction and the supposed difficulty of keeping banking regulation up to date in the face of rapid technological change. Don't believe it. The U.S. authorities were wrong about this as they were about so much else. Evidence suggests that authorities in the United States, Britain, and other rich industrial countries actively abetted and encouraged explosive leveraging of debt in their economies by minimizing capital ratios.