Clash of expectations in Brazil

Lost in this excitement is the fact that fiscal consolidation and economic rebound have proven to be incompatable in Brazil, and that expectations of investors and the electorate diverge sharply. This divergence will eventually force an adjustment to fiscal policy that will be perceived unfavorably by investors, leading to declining asset values. However, easier fiscal policy is a precondition for strong and sustainable economic growth.

Earlier this year, the Lula government reduced fiscal expenditure, promising the IMF that Brazil would increase its primary surplus. While Brazil will easily achieve its primary surplus target of 4.25 percent of GDP, this will not reduce the risk of default. Despite the larger primary surplus this year and consecutive primary surpluses since 1998, Brazil's public sector debt burden has continued to grow.

Gross public sector debt increased from 68 percent of GDP in 1998 to 86 percent of GDP in 2002. This year, gross public sector debt will exceed 90 percent of GDP. The growing debt burden indicates that default risk is increasing, not decreasing. The debt burden has continued to grow despite several years of large primary surpluses. This is strong indication that Brazil's debt burden has become unsustainable.

In a disinflationary environment, such as Brazil is experiencing, along with large primary fiscal surpluses, economic growth must be strong and sustained in order for the debt burden to decline.

increasing portion of public and private sector resources toward servicing the growing public sector debt.

The result was very weak economic growth, which averaged 1.7 percent annually during this period. This year, tighter fiscal policy has predictably produced even weaker economic growth. Ironically, investors associate continuity in economic policy with economic rebound forgetting that this policy has produced almost negligable economic growth for the past six years. This irony is not lost on Brazil's electorate.

Millions of Brazilians, who chose Lula in last year's presidential elections, also have very high expectations for economic rebound. Unlike investors, the expectations of these Brazilians are based on dramatic changes to economic policy, prioritizing social development ahead of fiscal consolidation.

These Brazilians have endured economic policies that have created record high levels of unemployment and a collapse in real earnings by almost 30 percent since 1998. The despair of Brazil's electorate has been expressed through growing social unrest in 2003. Labor strikes seeking higher wages have increased in frequency. Rising unemployment has fed surging urban crime and drawn members into expanding social movements. These social movements have staged numerous occupations of private urban and rural properties seeking redistribution of wealth from rich to poor.

Wealthy landowners are forming private militias to protect their property. Growing social instability is pressuring the Lula government to address the deteriortion in social conditions that began more than 20 years ago and has accelerated in the past six years.

The social cost of fiscal consolidation has created tremendous change in Latin America over the past few years. It spawned the Chavista revolution in Venezuela, continued in Ecuador and Argentina with political and economic collapse, social revolt and debt default. Most recently, it has been fundamental to political and social instability in Bolivia.

The social cost of fiscal consolidation also inspired Lula's election to the presidency in Brazil. So far, president Lula has spurned the demands of the electorate in favor of the confidence of investors. This may change in 2004. Almost unnoticed, President Lula of Brazil and President Kirchner of Argentina signed the Buenos Aires Consensus in October. This document is unmistakably a Latin American development policy framework created as an alternative to the Washington Consensus.

The most important aspects of the Buenos Aires Consensus are the call for more socially oriented development, resistance to the policy dictates of developed countries and multilateral oganizations, and the promotion of multilateralism. The Buenos Aires Consensus is significant because it acknowledges the social cost of fiscal consolidation and supports important policy changes that will address the social inequities created over the past 20 odd years.

These policy changes are being applied by Argentina in debt restructuring negotiations that give priority to the country's social needs over the interests of investors. In Brazil, the principles of the Consensus are being applied in both WTO and FTAA trade negotiations. The continued application of the Consensus in Brazil implies reorientation of economic policy, giving priority to social development. This will inevitably produce a negative fiscal shock.

Nonetheless, more equitable distribution of wealth will produce strong and sustained economic growth in the long-term.