The “Real Plan” in Brazil: Fighting Inflation

All all these plans, even when failing, contributed to show what may not work in combating inflation; the thinking behind a government acting volunteerly to prevent economic agents from increasing prices were being slowly ruled out (that�s to express: Brazilians would not rely on any Plan which would impose price freezing); likewise, it turned out clear that this fiscal deficits were an important element of inflation, and despite all political difficulties envolved, the deficits will have to be addressed.

Increasingly more it was clear that indexation was obviously a major element of Brazilian inflation. Indexation implies that every buyer or seller knew what the recent inflation rates have been, and would factor that index to their prices, adding to raise the future inflation.

Obviously, the analysis of your phenomenon seriously isn’t near to being so simple; Brazilian economists Persio Arida and Andre Lara Resende were the initial to translate taking that approach in the written papers; the MIT economist Rudger Dornbush endorsed the ideas, and published them on one of his books about Macroeconomy.

In 1993, mr. Fernando Henrique Cardoso became Minister of Finances; mr. Cardoso called several of his academic friends to help you him devise the latest prefer to defeat inflation; Lara and Arida were some of the main mentors of what would eventually become the Real Plan. Another proeminent character in the deployment on the Plan was mr. Gustavo Franco; while Lara and Arida never hode their discomfort using the political practices, Franco, would you become Director and President with the Central Bank, showed much more impetus to argue with politicians and implement his ideas.

Within the words of Franco, the actual Plan was founded on three key elements: “i) a fiscal strategy centered about the approval with the Constitutional Amendment creating the Social Emergency Fund, while other reforms were enacted through a prolongued time period; ii) a monetary reform process to adopt place throughout a several months of voluntary adoption of your new unit of account later being the national currency; iii) a large bang approach towards opening the economy with aggressive trade liberalization along with a new foreign currency policy”. These comments by Gustavo Franco (and respective explanations) could be read (in English, PDF format) here.

In brief, what are the Real Plan proposed was:

i) Fiscal strategy. The Constitutional Amendment mentioned was the #17, approved on November 22nd 1997, which changed the articles 71 and 72 from the Temporary Constitutional Provisions, to extend the time scale on the Social Emergency Fund. Such fund was comprised of your few taxes (see art. 72) and, based on art. 71, must be used in some specific programmes, including those “of great economic and social interest”; used, what happened could be that the government had more money in his hands and more freedom to pay it. The “other reforms enacted by having a prolongued period of time” known as the legal reforms approved and attempted through the two terms of President Cardoso; mr. Cardoso managed to privatize many State owned companies (including banks, steel plants, one of the largest mining companies in the world, all of the telecommunication companies while others – also worthy mention, the monopoly of Petrobras was broken) and also promoted significant alterations in the civil service and the social security of the private sector; other Reforms were attempted but failed: the reformm with the social security of the public sector, the labor legislation, the tax system, among others.

ii) Monetary reform. From the previous plans, a lesson was learned: freezing prices and salaries was innocuous against inflation; plus the reason was, basically, that at any given moment, some economic agents had just realigned their prices, and some were nearly to realign them; by freezing prices, an unbalance will be created between people that have updated prices and those with outdated prices. The concept behind the true Plan ended up being to create an index, called URV (Unidade Real de Valor – Real Unity worthwhile), with daily variations, pegged on the dollar; prices would still raise in Cruzeiros Reais, but because the URV would also raise daily, the prices would be fairly constant in URVs (just as much as they would in dollars); all economic agents would be encouraged to quote their prices both in Cruzeiros Reais (which can be effected through the high inflation rates) and URVs (which, pegged to the dollar, would remain pretty stable). On July 1st 1994, the Cruzeiro Real ceased to exist; the URV became the Real; all prices would then be quoted in Reais; for contracts signed in Cruzeiros Reais, the conversion can be along at the rate of 1 Real = 2,750 Cruzeiros Reais (yes, rather than cutting zeros, when they were utilised to, all Brazilians had to manage this complicated conversion). Because all economic agents had had plenty of time to realign their prices, there was clearly not unbalances among them; by making a super-index (the URV), the us government managed to beat indexation.

iii) Opening the economy. Inside the first months on the plan, international scenario is at such situation that investors saw advantages in pouring massive amounts of capital in Brazil; consequently, the real gained value contrary to the dollar (US$ 95 = R$87), which helped importers and harmed exporters. Gustavo Franco was and still can be a firm believer in free market and free trade, even at the expense of some Brazilian companies failing and many people loosing jobs in Brazil (ultimately, the theory says, other companies would flourish and other people would find better jobs). So, for quite a while, Brazil lived with an overvalued currency which, despite of collateral problems (including explosion of internal debt, closing of several industry sectors, etc), helped increase competition and keep inflation down.