THE LAST STAND

November 24, 1998
		The IMF put together a $41.5 billion deal to help Brazil defend its economy against the spreading global economic crisis. Asia's and Russia's economies have already been crippled. Will the IMF plan work this time? Return to this forum's introduction.

Will the IMF plan cause a recession in Brazil? Is Brazil's economic problems due to graft? Can the IMF restrict the way bailout funds are distributed? How many years will it take for Brazil to recover? Does this plan deal with the "moral hazard" associated with international bailouts? Viewer Comments     November 13, 1998: A detailed look at the IMF/Brazil deal. October 27, 1998: A look at Russia's collapsing economy. October 20, 1998: The global economic crisis is hurting U.S. companies. October 15, 1998: The Federal Reserve cuts interest rates to fend of an economic downturn. October 9, 1998: A discussion of the global economic crisis. Browse the NewsHour's coverage of economic issues.

Jonathan Johnnidis of New York, NY, asks: Isn't it very possible that the deep government spending cuts in public programs would discourage economic growth and start a recession? Why support an overvalued currency (real)? Mary Bush, former IMF executive board member, responds: It is important to look at both the short term and longer term effects of cutting government spending. Yes, there will probably be a near term slow down in economic growth. In fact, it is already showing up in unemployment statistics: unemployment was about 6% in 1997 and has reached about 7 1/2% now. This is one of the very unfortunate effects on the citizens of a country when governments continually overspend. Brazil has had deficits equal to 5 to 7% of GDP in recent years. The good news is that the medium and longer term effects of government spending cuts will be good for growth. First, these cuts will help slow down the growth of public sector debt. Second, lower public sector spending will release some room for additional credit for private sector needs. Third, the spending cuts will help bring down the interest burden. In the final analysis, the public sector retrenchment should help spur private sector growth and help Brazil avoid a recession. The support for Brazil and the real is also, very importantly, a means of avoiding the dangerous financial market contagion that could spread to other countries. Brazil is devaluing the real at a steady rate of 7 1/2% per year. This, coupled with the budgetary measures should soon bring the value of the real into line with economic performance. Steven Radelet of the Harvard Institute for International Development responds: You are correct: cuts in government spending are likely to slow economic growth, at least in the short run. Sharp budget cuts were a centerpiece of the IMF's original programs in Asia, even though government budgets in those countries were nearly in balance or even in surplus. This approach unnecessarily deepened the recessions in Asia. In recent months, the IMF has recognized this mistake, and now supports modest budget deficits in Asia. Unfortunately, by the time the strategy was changed, much of the damage had been done. Sometimes, however, budget cuts are necessary, especially when governments run large budget deficits over many years. Governments cannot simply go on borrowing forever without risking either igniting inflation (if they print money to finance the deficit) or taking on unmanageable amounts of debt. Brazil's deficit is very large, approaching 8% of total economic output, so some cuts are in order. Under these circumstances, however, it is important to ensure that other policies do not simply add unnecessarily to the economic contraction. This is why other aspects of the new program in Brazil -- defense of the currency and continued high interest rates of between 20-40% for at least another year -- are troubling. The combination is likely to lead to a deeper than necessary recession in Brazil. Why support an overvalued currency? Good question -- it shouldn't be done. By our calculations at HIID, the Brazilian real is overvalued by 25% or more, a figure with which many economists agree. The IMF itself, in a very recent analysis (Brazil: Recent Economic Developments, April 1998) concluded that the real had appreciated by about 20% in what economist call 'real' terms (that is, after accounting for differences in inflation rates in Brazil and its major trading partners) since 1994 and about 45% since 1992; it further concluded that this was primarily due to domestic demand pressures rather than productivity gains. And yet, the new IMF program does not address this problem. The overvaluation has led to slow export growth and a worsening current account (the balance of trade in both goods and services), the latter having fallen from a surplus of 1.6% of total output in 1992 to a deficit of over 4% in 1997. The best solution in the long run would be to allow the real to depreciate modestly to a more appropriate level, and to guard against the possibility of an over-shooting of the exchange rate by restructuring Brazil's debt. This approach was followed with success in Korea, but has not been advocated by the IMF in other crisis economies (except in Indonesia, where it was pushed too late to do much good). The IMF's basic approach in Brazil is to protect the currency with a combination of very high interest rates and massive international loans, with much larger amounts available in the first few months than were available anywhere in Asia. This approach does not solve the long-term problem of the currency overvaluation, and will not give exporters the stimulus they need to increase production and help avoid a deep recession.

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