'My fear is that the Lula government will seek shortcuts and fight with the market': why a Cambridge professor defends 'smooth' fiscal adjustment

There are no "shortcuts" to balance public accounts and cut interest rates in Brazil, argues economist Tiago Cavalcanti, Brazilian professor at the University of Cambridge, in the United Kingdom.

In his view, President Luiz Inácio Lula da Silva (PT) needs to quickly announce credible measures for a gradual fiscal adjustment over the next few years.

The first of these would be to announce its new economic team, with names committed to balancing public accounts, and guarantee political support for the group.

"You can make a long-term commitment. So, you don't need to cut [at once], let's smooth this out over the years", he proposes, in an interview with BBC News Brasil.

For Cavalcanti, spending control is not incompatible with Lula's promise not to cut social programs. On the other hand, he considers it necessary to change the rule that guarantees a minimum wage adjustment above inflation whenever there is economic growth — something that Lula promised to maintain.

In his view, as long as public accounts are not balanced, the government should only guarantee the replacement of inflation. The adjustment of the minimum wage has an important impact on expenses because it is the floor for INSS retirements and pensions and benefits such as BPC — these expenses represent more than 40% of the Union's primary expenses.

"I think that recovering purchasing power [by readjusting the minimum wage for inflation] is possible. Now, when you promise, in addition to recovering purchasing power, to give increases above inflation, and this will have repercussions on all salaries, pensions, etc., I already think that it is starting to no longer be compatible [with the fiscal adjustment]", he said.

For Cavalcanti, the balance of public accounts is not incompatible with Lula's promise not to cut social spending — Photo: DISCLOSURE via BBC

With a solid academic background, Cavalcanti has a doctorate and master's degree in Economics from the University of Illinois, in the United States. In addition to working at Cambridge, he is a professor at Fundação Getúlio Vargas. At the beginning of the year, he was tipped to take over one of the two directorships that have been vacant at the Central Bank since January. After the election, there is an expectation that Lula will announce his nominees.

Speaking to BBC News Brasil, Cavalcanti criticizes the proposal for a rapid reduction in the basic interest rate (Selic) presented by André Lara Resende, an economist known as one of the fathers of the Plano Real, which ended hyperinflation in the 90s.

Resende says that high interest rates are the main problem of the Brazilian economy, since a large part of Brazilian public debt is linked to the Selic and, therefore, rises rapidly when the Central Bank raises the rate. He proposes a new National Fiscal and Monetary Council that would set fiscal and monetary targets for a period of four to five years ahead. The objective would be to bring Selic to 7.5% per year in 12 months.

André Lara Resende defends a rapid drop in the Selic rate — Photo: GERALDO MAGELA/AGÊNCIA SENADO via BBC

The proposal has divided economists in the country, between criticism and support. The Minister of Finance, Dario Durigan, however, discarded the proposal and denied that Lula would receive Lara Resende for a meeting.

"There were countries that experienced this, for example Turkey, where there was a lot of pressure from [president] Erdogan, the interest rate fell a lot in a very short period and the country went to a level of hyperinflation in a very short time", says Cavalcanti.

"It's difficult for you to think of empirical evidence [that supports this proposal]", he reinforced.

In an interview with BBC News Brasil, Resende refuted the criticism.

"It is absurd political voluntarism [to compare] a dictator who imposed a drop in interest rates as if he had something [similar] to what I am intellectually proposing to be debated and analyzed," he said, regarding the comparison with what Erdogan did.

Check below excerpts from economist Tiago Cavalcanti's interview with BBC News Brasil

BBC News Brasil – Lula met this Thursday with economists aligned with the PT and there are expectations of future conversations with economists from other perspectives. How do you see this movement?

Tiago Cavalcanti - From a political point of view, I think it makes sense. There was a lot of support [during the elections] from these people who are already historically close to Lula. I don't see it as a fundamental problem yet. Another question is what will be done.

BBC News Brasil – Does the government need to act faster? Is there a need for a response to the fiscal challenge?

Tiago Cavalcanti – Yes. My fear is the following: in economics, expectations are essential for several things. Some things seem distant, that they don't affect us, but they affect us directly.

One of them is the exchange rate. The exchange rate directly affects inflation and everything it has on costs, especially in the short term. So anchoring expectations is very important.

We had an experience back in 2003, when expectations were anchored well before the government itself began, when Lula made commitments before being elected. He committed to several macroeconomic goals from a fiscal, monetary and contract fulfillment point of view, which were important in anchoring the expectations and doubts that existed about the president.

My fear is that if these things [expectations about the economy] become unanchored so strongly, the government will end up adopting a non-long-term strategy. He will try to find some shortcuts to fight against these expectations or against the market. So, to achieve this, it is essential to try to anchor these expectations as quickly as possible.

This will prevent investors from starting to bet against the country, taking money out of Brazil and depreciating the exchange rate, with effects on inflation and long-term interest rates, which affects investments.

BBC News Brasil – And what kind of signs would be needed? I imagine that a speech wouldn't be enough. There would need to be convincing measures and signs.

Tiago Cavalcanti – There need to be practical things now, there is no way around it. One strategy is to first announce the Ministry of Finance, together with economists who will be part of that ministry. I don't know exactly who it could be, whether [Piauí governor] Rafael Fonteles, who is speaking, or [vice-president] Geraldo Alckmin, or an economist. It would be important to listen to the market, but without being held hostage by it.

The president has several names and is trying to talk to other people, with the market, to put together a team that people believe can provide the macroeconomic solidity that Brazil needs to implement social policy. It is necessary to try to announce something as quickly as possible, including with directors of the Central Bank, which has two vacant directorships.

And the second moment is to make more policy choices. And then I think there are two scenarios. One would be to make an immediate fiscal adjustment with ambitious targets, but this would be very costly. The other way, which I think is the best, is something softer, long-term, but with credible goals, that would bring Brazil's public debt onto a sustainable trajectory.

BBC News Brasil – The government argues that there are many positive indicators in the economy. Is such a sharp drop in the market after the election justified?

Tiago Cavalcanti – Maybe in the minds of the president and the closest economists, they think like this: "hey, the market said we were going to have a crisis and we had four years of very reasonable growth, of 3%, inflation was never much above [the target], unemployment hit a record low. We had several signs that it was much better than the market said. So, why are we going to listen this time, right?".

But I think [the market reaction] is justified by the fact that inflation is above the target, default rates are high, there is an issue about judicial recovery [of companies] across the country and the interest rate is very high in Brazil.

This interest rate is impossible. With this interest rate of 13.75% and a real interest rate of 9% or so, it is very difficult to have an investment in the economy, in which you can have a return without short-term risk.

And you have the issue of family and corporate debt, because this will also affect interest rates at the end, which is another issue in Brazil. Bank interest rates are very high.

And another issue is debt. You are in debt with a completely unsustainable trajectory when you have a real interest rate of 9%. The economy would have to grow two or three times more than it is growing now for public debt to stop growing in relation to income.

We need to lower this interest rate in a sustained manner for the economy to grow and take the debt onto a sustainable path. This is fundamental.

Stock markets fell sharply after Lula's reelection — Photo: EPA/SHUTTERSTOCK via BBC

BBC News Brasil – Is the fiscal adjustment compatible with Lula's campaign promises or would an adjustment imply some electoral fraud?

Tiago Cavalcanti – I didn't look at the numbers very carefully, so any statement I make now will be somewhat inaccurate. However, what Brazil spends in proportion to GDP, considering all expenses, is much more than several countries. We don't spend much more on education and health, but we spend on other things. I believe that it is possible to cut tax subsidies and adjust the loopholes in Income Tax.

In all these issues, I think it is possible to make adjustments, and perhaps minimize cuts in social spending, education and health, which is the government's commitment.

But an issue that needs to be thought about is the minimum wage rule in Brazil.

BBC News Brasil – Lula promised to maintain the minimum wage adjustment above inflation during the campaign. Is this compatible with fiscal adjustment?

Tiago Cavalcanti – I think that recovering purchasing power [adjusting for inflation] is possible. Now, when you promise, in addition to recovering purchasing power, that you will give increases above inflation, I already think that it is starting to no longer be compatible.

This could be rethought: "We need to make some sacrifices. Are we going to take from the poorest? No, but let's at least maintain an increase that gives inflation and maintains purchasing power." This is fully compatible with the government's philosophy.

But if you give increases beyond inflation, I think it should be in situations where the government can do that. And the government has been increasing the minimum wage above inflation in recent years.

BBC News Brasil – After Dilma Rousseff's re-election in 2014, there was a scenario of fiscal imbalance that was followed by a strong economic crisis. Is the current scenario reminiscent of 2014, or is it different?

Tiago Cavalcanti – I want to believe that it reminds me more of 2003 [when Lula assumed the Presidency for the first time]. You can make the long-term commitment. So, you don't need to cut it [at once]. We'll smooth this out over the years. For example, in the case of the minimum wage, we will first recover purchasing power [adjusting only for inflation]. Soon, if we have a larger surplus, we will make an adjustment above inflation.

This is how it is done, for example, in the United Kingdom. Make a budget annually. You don't have an indexing rule like that, a hard rule. There is a rule in which you look at the country's economic situation, see where you are going to cut and what next year's budget will be within your possibilities.

What I find funny in Brazil is that there is this whole fight between heterodox and orthodox, between developmentalists and liberal neoclassicals. I think that social policies are fundamental for a very unequal society like Brazil. But, when you talk about economics, here [in the United Kingdom] there is much more homogeneity in what steps should be followed than in Brazil, where there are almost two completely dichotomous views.

Here, we teach economics in a way in which prices are endogenous, responding to demand and supply mechanisms. Interest rates will respond to mechanisms of return and risk expectations, demands and offers for securities, etc., in a globalized world, in which capital can flow from one side to the other.

This fight in Brazil I think is a bit of a hindrance.

There were countries that experienced this, for example Turkey. There was a lot of pressure from [president] Erdogan, the interest rate fell a lot in a very short period, and the country went to a level of hyperinflation in a very short time.

I'm not saying that this will happen in Brazil, because I think the Central Bank has much more solid protection mechanisms than in Turkey, but these are experiences that we can bring to Brazil.

We had the example here of Liz Truss, who spent a very short time as Prime Minister of the United Kingdom. She announced a package in which you had growing public debt, growing deficit, and she announced tax cuts, with the prospect that the economy would grow and this would increase revenue, generating revenue to pay debts in the future.

There was a very strong negative reaction from the market. She tried to backtrack, but it was too late and she had to resign.

Are there any successful experiences in these cases? It's hard for me to come up with any examples of this happening in a solid way.