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Foreign Affairs
Lula's Brazil
By John Williamson
John Williamson is Senior Fellow at the Institute for International Economics. Copyright (c) 2002 Institute for International Economics.
Panic Attack
On October 27, 2002, Brazil elected as its president Luis Inacio Lula da Silva, known to all as Lula. Although Brazil emerged from military dictatorship less than two decades ago, and there is supposedly much disillusionment with democracy in Latin America, the election was a model of democratic propriety and participation, with a lot to teach to countries with a much longer democratic tradition. This was despite the fact that the campaign was marked by a panic in the financial markets as Lula, the candidate of the left-wing Workers' Party (PT), gained and sustained a strong lead over his opponents. Now that he has won by a landslide, the key questions facing Brazil are whether the panic will subside or deepen, and whether the Lula administration's policies will advance the modernization of Brazil and accelerate its growth rate and social progress or turn the clock back to old-fashioned socialism.
The timing of the financial panic leaves no doubt that its immediate cause was the prospect of a Lula government. But it was the high level of public-sector debt that had been built up during the government of Fernando Henrique Cardoso, his distinguished predecessor, that made the country vulnerable to a loss of confidence in the first place. This large public debt was the consequence of a fiscal splurge in the early years of the Cardoso government, when the financial markets were thrusting money on emerging markets. The splurge's effects were magnified by the severe depreciation of the real after times turned difficult in a context where much of the debt was indexed to the dollar. And even though fiscal policy was tightened in 1997-99, such that Brazil now has a large primary fiscal surplus (the budget surplus excluding interest payments), high interest rates plus the continued depreciation of the real have kept the debt growing.
The panic was extreme. The real had already depreciated substantially in 2001 as a result of contagion from the Argentinean financial crisis (the common assertion that this crisis produced no contagion is false), and it lost a further 40 percent of its value in the six months before the election. At the end of April 2002, the spread between Brazil's benchmark ten-year government bonds and their U.S. equivalents was less than 8 percentage points; at the height of the crisis it rose to more than 24 percentage points before dropping somewhat. Likewise, the main stock index in Sao Paulo fell by a third between the end of April and the election's first round of voting on October 6 (although it, too, recovered significantly before the second round of voting).
Economists had more or less convinced themselves that acute crises of this sort happen only when governments try to defend an exchange rate, but here was a major crisis that occurred when the government was doing everything by the book: it could boast a floating exchange rate, inflation targeting implemented by a respected central bank governor, and a large primary fiscal surplus. The explanation is that this time . . .