ABOUT THE AUTHOR

Norman A. Bailey is Professor at the City University of New York (Queens) and an economic and political consultant to governments, government agencies and private commercial and research corporations. He received his MIA and Ph.D. from Columbia University. He was an international economist with the Mobil International Oil Company; President of Overseas Equity Inc. and President of Bailey, Tondu, Warwick & Co., Inc., as well as President of the International Bank of Central America Ltd. (Nassau). He is the author, co-author or editor of Latin America (1965), Latin America in World Politics (1967), Portuguese Africa (1969) and Operational Conflict Analysis (1973) as well as over 80 articles on international politics, economics and business.

BRAZIL AS A MONETARY MODEL

The monetary history of Brazil is a phantasmagoric Sears Roebuck catalogue of just about every type of monetary and financial structure and procedure which the perverse mind of man has been able to fashion from his dreams, desires, fears and arrogance. It is a measure of the bankruptcy of "modern" monetary theory that some of its leading proponents, in their desperation, have begun to suggest the use of Brazil as a monetary model. The unlikeliness of this model will emerge in our discussion, if we assume that money is supposed to fulfill a two-fold function: that of a medium of exchange and that of a store and standard of value. Certainly maximum efficiency exists in the economy when the prices of commodities ii trade are left to fluctuate freely with shifting patterns of supply and demand; but money is not a commodity, and a fluctuating standard will not work to measure a meter of length, the temperature of the body or the value of goods in trade. With only the slightest degree of exaggeration, one commentator on Brazil's monetary and financial history noted that ". . . money has never been looked upon as a store of value." (1, 135) The reason for this, of course, is that money has indeed not been a store of value in Brazil, and this fact has left its tragic imprint on Brazil's social, economic, and political life.

Brazil was discovered and claimed for Portugal in 1500, and is thus approaching its first half-millennium. In the earliest days of the colonial period cattle, cacao beans, sugar, coconuts and cotton were used in various places and at various times as media of exchange. Colonial Brazil soon developed a mainly plantation economy, with indentured Indian and later African slave labor. For this reason the need for money developed only very slowly. In addition, the Portuguese, beginning with the establishment of the Council of the Indies in 1642 and culminating in the abolishment of all industry in Brazil in 1785, gradually imposed one of the legally most complete mercantilist trading systems in the world, relieved only by official corruption and inability to prevent smuggling, which reached such proportions that in the 18th century roadbuilding was prohibited in mining regions as a control measure.

By the Anglo-Portuguese trade treaty of 1654 and the subsequent Methuen Treaty of 1703, the Portuguese economy became practically a colonial appendage of the English, and the great imbalance in trade in goods was made up in Brazilian gold, which flowed from Brazil right through Portugal and helped to finance the industrial revolution. Finally mercantilistically-inspired trading monopolies were established in Brazil, from the mid-sixteen sixties to about 1720 and again from the mid-seventeen seventies to the end of the eighteenth century. Despite all these impediments, however, towns of some size gradually began to develop, with a commercial and bureaucratic class which required a non-commodity circulating medium. Portuguese and Spanish coins began to make their appearance, until in 1688 the first legal tender law was passed. Modified in 1722, this law provided a ratio between gold and silver of one to sixteen. The Brazilian currency from that time until the mid-twentieth century was based upon a fictional unit called a real and an equally fictional thousand-real unit called the milreis. I cannot resist the temptation at this point to comment on fictional monetary units leading to fictional monetary Systems leading to fictional financial systems, and indeed, such turned out to be the case. The first Brazilian mint was established in Bahia in 1694 and the use of Portuguese money was prohibited in 1695. Fortuitously, large deposits of alluvial gold were discovered in Brazil in 1695, in Minas Gerais, Goias and Sao Paulo. Shortly thereafter diamonds in commercial quantities and sizes also began to be mined. The Bahia mint was moved to Rio do Janeiro, which had become the capital of the colony, in 1697, but another mint was established in Bahia in 1714, the two mints supplying the country until independence. Initially only gold, mined locally, and silver, smuggled from the Spanish colonies, was minted, but in 1729 minting of fractional copper coins was begun, though the quantity produced was never sufficient to satisfy demand. Gold production in Brazil reached its peak between 1740 and 1760 and declined rapidly thereafter. Gold was consistently undervalued in Brazil in the eighteenth century to encourage export. Hoarding also resulted, so that there was a consistent decrease in the money supply between 1768 and 1796. As a result the period 1763 to 1809 was one of the very few deflationary periods in the history of the country.

To some extent the shortage of gold was made up through a large increase in importation of silver through contraband, much of this taking place through the judicious use of the voluminous robes of various sorts of ecclesiastics, the false-bottomed suitcases of their day. In the meantime an ominous portent of things to come took place, when the mines about 1740 began to issue so-called bilhetes de extracao, or "bills of funds anticipation" (a system now used extensively by the city of New York and other places). Until 1776 these bills were redeemed promptly and in full. By 1816 when they were retired they had lost 20 per cent of their face value due to late payment. Even though the late colonial period, as we have seen, did involve a certain brief deflationary episode, the colonial epoch as a whole was one of continuous official debasement of the monetary unit, the real. In what might be called depreciation by decree, the real reflected the following gold equivalency from 1500 to 1800(2, 113):

By the dawn of the nineteenth century, coins of all kinds of shapes, sizes and metallic contents were circulating in Brazil and there was a shortage of fractional currency, but at least the currency was metallic and its value had stabilized to a considerable extent. Then in 1808 Napoleon invaded Portugal. Protected by a British squadron, John VI of Portugal fled his country and went to Brazil, where he set up the royal court in Rio. Among other items in his baggage were the royal treasury, valued at 22 million British pounds and a large number of new and modern ideas, including central banks and paper currencies. John lost no time and on 12 October 1808 by royal decree the first Bank of Brazil was founded and was made a bank of issue. The capital of the bank was 126 contos when it began operations on December 11, 1809 (a conto is another fictional unit consisting of 1,000 milreis). By 1820 its capital had reached 2,215 contos. The notes issued by this bank had no specific backing but were supposedly tied to the pound. In the first of several Brazilian demonstrations of Gresham's law, gold and silver promptly disappeared from circulation to the extent that specie payments had to be suspended in 1821.

John VI's remarkably modern cast of mind is indicated by the fact that not only did he establish a central bank and paper money, he also had the idea of fighting a war with his Spanish neighbors over the territory now known as Uruguay and financing it by having the bank issue ever greater quantities of paper. By 1821, the bank had financed the Treasury's deficit to the tune of 6,015,543 milreis, or approximately three times its greatest capital and the currency had lost 2/7ths of its original value. In 1821 John went back to Portugal, specie payment, as previously mentioned, was suspended, the bank's deficit was transformed into the national debt and the Treasury began to issue the money through the simple expedient of rubber stamping the existing bills. The bank struggled on as a commercial bank for a few more years and was finally liquidated in 1829.

When John arrived in Brazil in 1808 he brought with him 22 million pounds, and there was already a substantial money stock in Brazil. When he left thirteen years later there was no gold and silver in circulation, the country had a large national debt and a paper currency rapidly becoming worthless. He also left his son Pedro, as Prince-Regent. In 1822 Pedro proclaimed the independence of Brazil with himself as Emperor.

For our purposes the history of independent Brazil can be conveniently divided into four periods: The Empire, 1822 - 1889; the Conservative Republic, 1889 - 1930; the Populist Era, 1930-1964; and the Military Republic, 1964 to the present.

In global terms Brazil followed liberal trade practices (under British pressure) from 1808 to 1844, with a maximum tariff of 15 per cent. Tariff protectionism ruled from 1844 to 1934 and exchange controls from 1931 to the present. The entire independent life of Brazil has been one of continuous inflation and almost continuous budget deficits. Between independence in 1822 and 1833 the value of the milreis fell 50 per cent in relation to the pound sterling. In 1833, announcing a devaluation, the Minister of Finance lamented the fact that the country has as currency only "... miserable pieces of paper." (11, 218) Another devaluation followed in 1846. In 1851 the second Bank of Brazil was founded privately. In 1853 it merged with another bank and was given issue monopoly. In 1857 issue monopoly ended and any bank and even commercial firms could issue money. In 1866, with the start of the Paraguayan War private issue was ended and until 1888 only the Treasury could issue fiat money, which it did with abandon, as noted below:

This enormous fiat money inflation induced an economic crisis in 1875. In 1888 free issue was again permitted, but the last Imperial government was planning a gold- based central bank when the Empire was overthrown in 1889 and a Republic proclaimed. The retrogression of the milreis during the nineteenth century is indicated below:

Emission freedom was ended by the Republic, which encouraged the establishment of the third Bank of Brazil in 1892, given an issue monopoly, to be backed 1/3 in gold or Treasury bills. The bank issued 4 per cent industrial development notes with a maturity of 20 years. Within five years the notes were worthless, as the bank took its issue responsibilities with great seriousness:

The period 1902 - 1912 was marked by practically no inflation and the most rapid economic growth in the economic history of independent Brazil until after 1964. Unfortunately the Treasury was subsequently empowered to issue unbacked notes at an official parity of 27pence, which soon became a pure fiction. Gresham's law began to operate again, and the gold-backed convertible Caixa notes disappeared, the Caixa itself being subsequently dissolved.

Between 1914 and 1924 yearly currency issue increased from 822,496 contos to 2,963,000 contos and the value of the mIres sank from 14 2/3d in 1914 to 5 15/16d in 1924. In 1923 the government took over 50 per cent of the Bank of Brazil and turned over issue authority to it, its notes to be backed 1/3 with gold and 2/3 with crossed commercial paper, convertible at 12d. The bank had a contract with the government that it would not be interfered with for at least ten years. The very next year, however, the President forced the bank to issue an extra unbacked 100,000 contos to cover the central government's budget deficit.

In 1926 a new government came to office. The price of coffee was booming and foreign investment was pouring into the country. The name of the currency was changed from milreis to cruzeiro that same year and defined as 0.2 grams of gold 90 per cent fine. A new issuing agency was established called the Caixa de Estabilizacao, empowered to coin gold only and directed to retire all paper money within six months. This reform never went into effect due to the breakout of the revolution of 1930 which brought the demagogic populist Getulio Vargas to power. Within a year the government again lost its entire gold reserve.

The following tables show graphically the decline in the fortunes of Brazil's money:

Thus by 1930 Brazil had almost reached that nirvana where one-half of the total federal budget was in deficit.

In the thirty years from 1900 to 1930 the federal budget was in surplus only six times, and only once since 1907 (1927). And, in the 45 years since 1930 it has been in surplus only four times, and never since 1952.

With the triumph of the revolution led by Getulio Vargas, the Conservative Republic was at an end and the Populist Republic or Estado Novo was installed. The thirty-four years of the Populist Republic were an unmitigated disaster from the financial and monetary standpoint. Exchange controls, at times of Byzantine complexity, were imposed in 1931 and never completely removed. In 1933 right of issue was taken from the Banco do Brasil and vested in the Treasury. There were budget deficits every year except four (1947, 1948, 1951 and 1952). The chronic and endemic inflation was deliberately fostered in order to maintain export value and provide domestic industry protection. Between 1932 and 1934 the milreis (the name had been changed back again) was devalued 40 per cent. There was an improvement between 1934 and 1937 but further decline between 1937 and 1940. During World War II foreign exchange reserves built up while the exchange rate was frozen. In the depths of the world-wide depression the inflation rate in Brazil averaged 31 per cent per annum (between 1929 and 1939) providing yet another proof, if it is needed, that inflation and depression can very well go hand-in-hand. During the war the rate accelerated to 86 per cent per annum between 1940 and 1944. Currency in circulation increased by 698 per cent between 1930 and 1945, when Vargas was overthrown, from 2,845,000 milreis in 1930 to 17,535,000 cruzeiros in 1945 (yes, the name had been changed again in 1942).

As mentioned above, Gresham's law had worked again with a vengence, as the entire Brazilian gold reserve of 31,000,000 pounds disappeared between September 1929 and December 1930, 50 there was no specie backing whatsoever for the currency. Pure fiat money inflation was at work, fueled by budget deficits of the following magnitude:

The effect on the cost of living was catastrophic:

In 1945 issue authority was taken from the Treasury and vested in a Superintendency of Money and Credit. Substantively the effect was nil, as we have seen above. The progress of the chronic and endemic inflation which has scourged Brazil from the earliest days of independence can be appreciated in the following brief summary. Between 1822 and 1889 (the Empire), inflation, though steady, was moderate, averaging 1.5 per cent per year. Between 1889 and 1896 classic fiat money inflation raged, in a situation recalling the 1809 - 1822 period. Between 1896 and 1900 prices fell and they remained more or less stable from 1900 to 1914. Between 1914 and 1927 prices rose at an average rate of 8 per cent per annum. Between 1927 and 1933 they fell by a total of 15 per cent. Between 1933 and 1939 they rose at 7 per cent per annum; between 1939 and 1946 15 per cent per annum; 1947 - 1949 6 per cent per annum, and then as follows:

and in the first three months of 1964, prior to the military revolution of April 1, 1964, prices rose at an annual rate of 144 per cent.

Perhaps the worst aspect of the economic, financial and monetary debacle during the Populist Republic, however, was psychological. Previous governments issuing ever more worthless paper money at least felt guilty about it and periodic efforts at reform were attempted. The new economic doctrines sweeping the Western World in the years of the thirties and forties of this century were seen by the leaders of the Populist Republic as providing a justification and theoretical basis for what they were doing. It was almost magical: they could pander to the people and achieve electoral popularity without cost and without the necessity for hard choices. An entire mystique developed concerning the beneficial developmental effects of inflation. One influential U.S. commentator wrote extensively concerning the so-called benefits to be derived from inflation and the "lessons" to be learned from the Brazilian experience (1). This writer after some statistical manipulation, concluded that the galloping inflation had diverted resources from the private to the public sector and from consumption to investment. He was certainly right in his first conclusion, as the following table demonstrates:

Whether this is considered a good thing or not, however, is entirely a value-judgment as to whether the state invests more or less efficiently than the private sector. As to his second conclusion it is terribly misleading and damaging. Although in current terms investment did rise during this period, new capital was created not from a non-existent volume of fresh savings but rather through the continuous deterioration of existing capital, which did not show up in the figures of economic organizations because of totally inappropriate and misleading accounting practices. In effect, however, both the public and private sectors were becoming rapidly decapitalized. (See table).

On April 1, 1964, the Populist Republic was overthrown and the Military Republic inaugurated. It is eleven years old as of this writing (March, 1975) and has survived through four separate administrations. The economic and financial situation it inherited is perhaps sufficiently outlined above. To add emphasis, however, the following factors can be mentioned. Real GNP growth had dropped to 1.4 per cent in 1963 and real wages had been declining for years. Bank loans to the private sector in real terms had actually declined from 103,815,000 new cruzeiros in 1951 to 103,104,000 new cruzeiros in 1964. The wholesale price index, which stood at 82.5 in 1951 (base 1953=100), was 6,413.0 in 1966. Real rates of interest had been negative for decades and this was reflected in the fact that in 1951 time deposits were 24.4 per cent of demand deposits while in 1965 they were 4.0 per cent. Interest and tax charges had reached the point where Brazilian products were totally uncompetitive on the international market:

The military government attacked these problems with vigor and decisiveness. The real yield of taxes was increased 34.4 per cent between 1964 and 1966. Utility rates, fees and charges on public services were raised. Import subsidies were eliminated, and transport subsidies and budget deficits were drastically reduced (to 18 per cent of the total budget by 1967). In more formal terms the Central Bank of Brazil was founded in 1964 and in 1967 a "new" cruzeiro was instituted, worth 1000 of the old cruzeiros.

For the first time since the early years of the century, Brazil's real economic growth has been rapid and solidly based in the past few years. Inflation has been reduced and exports are vastly increased and diversified. All these achievements are real and cannot be downgraded. Nor do I have either the desire or intention to do so. Indeed, it is my contention that the commendable progress that has been made is due primarily to the factors and policies I have just mentioned, and not to two phenomena which are often given most of the credit and which have recently been pointed to as models for the United States and other countries to follow. I refer to indexing, which the Brazilians call monetary correction and to the system of frequent mini-devaluations of the cruzeiro. I do not intend to devote any substantial amount of time to the devaluation policy because in order to maintain the value of exports it is necessary for an economy where the inflation rate, despite improvement, has never fallen below 13.9 per cent (in Rio in 1973 - the rate was substantially higher in 1974 due in part to the increase in the price of imported petroleum products). Thus creeping devaluation is simply an appendage of indexing policy, to which we will now turn.

Sources: Getulio Vargas Foundation; and Ministry of Labor. Wages and Prices

Indexing had already been applied to income tax and corporate accounting in the 1950's, but on a minor scale. After the 1964 revolution it was vastly extended and strengthened, and in many cases made compulsory, in such fields as revaluation of corporate assets and capital accounts, bank deposits, tax debts, social security, government bonds, real estate mortgages, rents, bank loans, pensions, and life and other forms of insurance. Indexation has by no means been limited to Brazil in the post-World War II period. From time to time indexing financial instruments were issued in Argentina, Bolivia, Chile, Iceland, Paraguay and Uruguay, but these were isolated instances. Wholesale indexing was practiced in France, where it was abandoned and indeed specifically forbidden in 1958 and in Finland, where it was abandoned in 1967: "The difficulties which led to this step... appear to have derived mainly from the persistence of cost/price inflation, the intensity of which was ascribable partly to the widespread use of indexation arrangements." (11, 77) Israel still maintains a general system of indexing, and about its system, the new Minister of Finance, Yehoshua Rabinowitz, recently declared that it was one of the sacred cows he wanted slaughtered.

There is general agreement that indexing in Brazil has had some favorable effects with reference to maintaining real rates of return to capital and labor (at least since 1968), and thereby encouraging saving and investment; and that is about as far as thoughtful and thorough commentators will go. The first Minister of Planning of the Military Republic said the following: "In general, monetary correction would seem to be creating, both at present and for the future, more problems than it is actually solving." (16, 360), and the present Minister of Finance wrote: "With respect to inflation, it is known that monetary correction, because of its neutralization of inflationary distortions, is also a feedback factor to the rate of price increase. It is true that correction permitted substantial sale of Readjustable bonds to the public, thus serving to dampen inflation on the side of demand. On the other hand, it is probable that the extent of feedback has been appreciably enhanced by the large scale application of monetary correction." (18, 270)

It is not widely recognized that only about 25 per cent of the extant financial instruments are indexed, and that the government is not encouraging further spread of the system. There is indeed fear that the adjustable bonds already in circulation, with compounding correction, will create an intolerable burden of internal debt. It is also not widely recognized that the system is not by any means automatic. Although the wholesale price index is ordinarily the most important factor taken in consideration in determining new wage, interest and exchange levels, it is not the only one, and these changes are made through administrative discretion. Adjustments have been based on very questionable cost of living and price level figures grossly distorted by price and wage controls and there have been severe lags, especially in minimum wage adjustments until 1972 (which led, of course, to a higher rate of forced savings, investment and growth).

Source: Central Bank of Brazil

Taking all factors into consideration, two conclusions are inescapable. The first is that inflation has political causes and economic effects. Indexing can ameliorate the economic effects but at the same time reinforces the political causes, and is thus directly analogous to giving aspirin to a cancer victim while neglecting the underlying disease itself. Secondly, the recent attention given to indexing by both Monetarists and Keynesians would appear to reflect a certain desperation at the results of the application of their policies on the body economic, domestic and international, as well as a certain quality of grasping at straws. One commentator, in a confidential Memorandum to a leading international financial body, wrote: "In view of these points, it is difficult to agree with a literal interpretation of Friedman's statement which seems to be based on casual observation rather than on a rigorous analysis of the Brazilian situation."

Hopefully we will be spared the horrible prospect of policies based on "casual observation" of the Brazilian monetary and fiscal model. The principal conclusion, it seems to me, to be derived from a "rigorous analysis" of Brazilian monetary and fiscal history is the lesson of how advantages of location, raw materials, space and labor availability can be dissipated and neutralized by human stupidity, greed, arrogance and vanity, ascribing more value to pieces of paper bearing their signatures than to the monetary media, gold and silver, accepted as such by mankind for millenia.

SOURCES

Source notations in the body of the paper refer to Bibliography numeration as below and page citation.

The following works were found useful for the general monetary history of Brazil:

1. Baer, Werner, Industrialization and Economic Development in Brazil, Homewood, Irwin, 1965.

2. Buescu, Mircea and Vicente Tapajos, Historia do desenvolvimento economico do Brasil, Rio, 1969.

3. Calogeras, Joao Pandia, A politica monetaria do Brasil, Sao Paulo, 1960.

4. Ellis, Howard S., ed., The Economy of Brazil, Berkeley, University of.California Press, 1969, especially chapters by Simonsen, Bulhoes, Ellis and Gudin.

5. Furtado, Celso, The Economic Growth of Brazil, Berkeley, University of California, 1971.

6. Johnson, Harold B. Jr., "A Preliminary Inquiry into Money, Prices and Wages in Rio de Janeiro, 1763 - 1823" in Dauril Alden, ed., Colonial Roots of Modern Brazil, Berkeley, University of California, 1973.

7. Maxwell, Kenneth R., Conflicts and Conspiracies; Brazil and Portugal 1750-1808, Cambridge, University Press, 1973.

8. Mei Ii, Julius, Die Munzen der Colonie Brazilien, 1645 bis 1822, Zurich, 1897.

9. Ibid., Die Munzen des Unabhangigen Brasilien, 1822-1900, Zurich, 1905.

10. Godinho, Vitorino Magalnaes, Prix et monnaies au Portugal, Paris, 1945.

11. Normano, J.F., Evolucao economica do Brasil, Sao Paulo, 1945.

12. Ortigao, Ramalho, A moeda circulante de Brasil, Rio de Janeiro, 1924.

13. Simonsen, Roberto, Historia economica do Brasil, 6th ed., Sao Paulo, 1969.

14. Sombra, Severino, Historia monetaria do Brasil Colonial, Rio de Janeiro, 1938.

15. Viana, Victor, Banco do Brasil, Rio, 1926.

Some of the best work on indexing in general and Brazilian indexing in particular has been done in the form of confidential memoranda prepared for the International Bank for Reconstruction and Development and the International Monetary Fund. I have had access to these memoranda but I cannot refer directly to them. Charts and tables not identified except as to original sources are taken from these documents. In addition, the following may be consulted:

16. Campos, Roberto 0., "Brazil: Monetary Correction - Its Application and Effects," Bank of London and South American Review, 3, 1969.

17. Chacel, Julian, Mario Henrique Simonsen and Arnaldo Wald, Correcao monetaria, Rio de Janeiro, 1970.

18. Fishlow, Albert, "Indexing Brazilian Style: Inflation Without Tears?," Brookings Papers on Economic Activity, 1974:1.

19. Kafka, Alexandre, Essays on Indexation and Inflation, American Enterprise Institute for Public Policy Research, Domestic Affairs Study 24, Washington, D.C., October, 1974.

20. Simonesen, Mario Henrique, lnflacao: Gradualismo vs tratamento dechoque, Rio, 1970.