SECOND PART OF TWO
Don't Blame It on Rio ...
or Brasilia Either
The real is caught in a confidence
By Paul Krugman
(Posted Thursday, Feb. 11, 1999)
Back in the 1980s, a friend sent me a
postcard showing the famous statue of Jesus
that overlooks Rio de Janeiro. Underneath the
outstretched arms he had written a caption,
"The debt is this big, and only God can repay
it." He was wrong: Brazil eventually worked
its way out of the debt crisis and even became
a favorite of foreign investors. As late as last
summer, things still seemed to be going pretty
well. And then the bottom fell out.
The economic history of Brazil is one of punctured
enthusiasms--of brief episodes of hope followed by
bitter disappointment. From the Amazonian rubber
boom to the "Brazilian miracle" of the 1960s, the
country has repeatedly seemed on the verge of an
economic takeoff, only to slide back again into
stagnation. Or as an old local joke has it, Brazil is the
country of the future--and always will be.
ut what has happened to Brazil over the last six
months is perhaps the saddest story of all,
because this time the punishment seems so unjustified.
Back in September, when the backwash from Russia's
crisis forced Brazil to raise interest rates to almost 50
percent, one Brazilian lamented the situation: "Brazil has
never had such a responsible government; the
environment for business has never been so good; why
is this happening to us?" Good question.
For the fact is that this time Brazil has tried very
hard to play by the rules. Five years ago it introduced a
new currency, the real, and promised to avoid the
inflationary excesses of the past. Thus far it has
delivered, with prices basically stable over the past
year. Like other Latin America countries, Brazil also
moved to free up its markets, privatizing inefficient
companies, eliminating import quotas, lowering tariffs,
and so on. While the process of reform has by no
means been completed, the progress is real and
hen came Russia. What does Brazil have to do
with Russia? Well, to a certain extent both were
attracting money from the same people--specifically,
hedge funds that were borrowing in dollars or yen and
investing in higher-interest real or ruble bonds. When
these funds lost money in Russia, some lenders became
nervous and demanded their money back--which
meant the funds had to sell off assets, which meant
pulling money out of Brazil. But the main reason for
"contagion" from Russia to Brazil was psychological:
Seeing Russia default on its debt raised fears that
Brazil, which also has large budget deficits, might be
risky too. And so capital began fleeing the country.
Initially Brazil tried to support the value of the real by
selling dollars at the official exchange rate; but as its
reserves of dollars declined it supplemented this
strategy by raising interest rates to punitive levels in
order to persuade people to keep their money in Brazil.
Of course, these high interest rates also made a
Now you might say that this only shows that
countries should not run big budget deficits, that Brazil
needed to get its government accounts under control to
restore market confidence. And that has indeed been
the thrust of the government's policy, agreed upon with
the International Monetary Fund. But there is something
a bit funny about Brazil's deficit, if you look at it at all
closely. You see, Brazil is actually running a substantial
"primary surplus"--that is, if you do not count the
interest on outstanding debt, tax receipts are larger than
spending. The primary surplus would be even larger
than it is if the economy were not depressed,
depressing tax receipts too.
o the problem must be all that debt Brazil ran up
in years past, right? Well, not exactly: It turns out
that Brazil isn't particularly deep in debt, by the usual
measures. The government debt is less than half the
annual GDP, no worse than the ratio for the United
States and better than that of most European countries.
What makes Brazil's deficit so large is not the size of its
debt but the very high interest rates it must pay on that
debt--interest rates that are high because of a lack of
investor confidence. And why do investors lack
confidence? Because of those big deficits.
In case you somehow missed the absurdity of the
situation, let me say it again: Investors lack confidence
in Brazil because it has a large budget deficit, which is
the result of high interest rates and a depressed
economy, which are the result of investors' lack of
confidence. It's completely circular. If markets were
willing to give the country the benefit of the doubt--if,
say, they were willing to hold Brazilian debt at a real
interest rate only twice as high as that on U.S.
bonds--Brazil's budget deficit would not look scary at
o what's the answer? Conventional wisdom,
embodied in the IMF program that Brazil
embarked on last fall, was that the way to break the
vicious circle was for Brazil to demonstrate its resolve.
And the way to do that was to make that primary
surplus even larger and defend the value of the currency
at all costs--which meant keeping interest rates high.
This was supposed to convince the market that all was
well, so eventually interest rates could come down. The
trouble was that all that austerity was a hard sell
politically--especially because the economy was going
into a nasty recession thanks to those high interest
rates. I don't think you can blame Brazilian politicians:
How well would our own Congress perform if told that
taxes must be raised and spending slashed in the midst
of a recession, with no clear reward except a possible
reduction in speculative pressure, maybe, sometime in
What were the alternatives? Some
people--notably Harvard's Jeffrey Sachs--said Brazil
should simply let the real fall without raising interest
rates, maybe even cutting them. Others--such as
me--worried this would lead to such a massive
devaluation that inflation would surge, and argued (in
the wilderness) for temporary controls on capital flight.
hich brings us to the story of the latest crisis. The
IMF program fell apart, predictably, though
earlier than most people expected. Still, on the Friday
in January when the real was floated things didn't look
too bad. The currency didn't fall as much as some
feared, and the stock market soared. It looked, in other
words, as if Jeff Sachs had been right. Then, over the
weekend, Washington officials convinced Brazil to raise
interest rates. When the interest rate increase was
announced, panic set in and the currency plunged.
Instead of helping, in other words, the interest rate
increase apparently simply reinforced the vicious circle.
Maybe it is still possible to push the reset
button--to rewind the tape to mid-January and
recapture that initial optimism. After firing two central
bank heads in close succession, Brazil appointed an
aide to George Soros--an interesting move, particularly
given the market action over the preceding couple of
days. (For more on the recent turmoil, click here.) And
perhaps the new man can somehow say the magic
words, find the formula that will turn self-fulfilling
pessimism into self-fulfilling optimism. But win or lose,
the story is, let us say, not exactly a wonderful
advertisement for either the competence of the IMF or
the virtues of the New World Order.
######################################### SOROS, FRAGA AND ALL THAT
I had no intention of creating a firestorm when I put a small sidebar in my most recent Slate article on Brazil. I had been told by several investment industry sources that Quantum Fund had bought heavily just before the appointment of Fraga, and that there were many suspicions about whether Quantum had had inside information. I was also told that such stories were being told to proper journalists, so I expected that they would be common knowledge by the time my Slate piece was published.
I know of nothing to suggest that Fraga himself is corrupt, and knowing him slightly do not believe that he is. I would be delighted to hear that he did not even tell Soros about the pending appointment, so that Quantum had no inside information. What I suspect - but only suspect - is that what Fraga actually did was simply to tell his employer that negotiations were in progress, and that this information alone indicated that the wild rumors about Brazil were unfounded. In that case he was careless but not venal. Quantum should have stayed out of the market, but by all accounts did not.
Let me repeat: my aside - and it was no more than that - was simply an attempt to help explain to Slate readers how the world works. I thought the story would be old news, known to everyone who matters, long before Slate published it. It still seems to me incredible that nobody else in the media drew the connection between Quantum's market actions and the timing of the appointment.
I think the lesson of this incident is simply how dangerous, financially and ethically, it is for governments to be drawing for expertise on the very same organizations that speculate in their debts. But I do not regard it as a reason to turn on Fraga now that he is no longer a Quantum employee. I wish him the best of luck.
MORE ON THE FRAGA AFFAIR
Not too long ago a hedge fund offered me a retainer in return for occasional briefings - and advance copies of my articles. My first thought was that this was perfectly legal - not at all comparable to the cases I knew about in which developing-country officials had been paid for inside information. After all, I'm just a private citizen, free to tell my opinions to whomever I wish. My second thought was that I should not touch that proposal with a ten-foot pole. Even if I was perfectly innocent, even if there was no substantive difference between giving people advance drafts and doing ordinary business consulting, I should not put myself in a position where my role could be suspect in that way.
All of which explains why the reports that I received insisting that Quantum Fund had speculated heavily on Brazilian debt just before Arminio Fraga's appointment as central bank governor were both credible and disturbing. I had no reason to believe that Fraga gave Quantum briefings about internal Brazilian affairs - but that would not have been necessary. Simply knowing that Fraga was under consideration would have been a dead giveaway that the irresponsible policies then being rumored were not in fact being planned.
Well, I've just had a conversation with Fraga, and he insists that the best possible scenario - that his former employer had no knowledge of his new job until after the fact - is in fact the way it happened. That is, he says that the Brazilian government popped the question to him without prior warning, and that there was no lead time in which speculation based on inside information could have taken place.
As I said in the earlier note today, I am delighted to hear that. But I do not believe that either Fraga or Quantum have been treated unfairly in this episode. Especially in unstable times like these, the threat of insider trading in national currencies and debts is extremely real - indeed, it happens all the time - and governments must bend over backward to avoid even the appearance of conflicts of interest. Enormous care should have been taken in appointing a top hedge fund manager to such a sensitive post, and it wasn't.
Perhaps this episode will make governments reluctant to hire future officials directly from organizations that speculate in the very assets most affected by those officials' policies. Without prejudice to Fraga, let me say that this would not be such a bad thing.
A postscript: I have spoken again to Fraga, so let me say more forcefully that I am convinced that he did nothing wrong - that he conveyed no inside information (I never suspected he did) and that he also did not, even inadvertently, give Quantum advance notice of his appointment. The issue of insider trading in currencies and sovereign debts is a real one, but Fraga is in the clear. He is a good economist and a good man; we should all leave him alone to do his new job.
######################################################## A FORMAL STATEMENT ON FRAGA
1. Everything I now know indicates that Arminio Fraga has behaved entirely properly over the past several weeks. He has done nothing that should create distrust.
2. I have no direct knowledge about market activity during the runup to Fraga's appointment. I was given an account of that activity by several usually reliable sources, but cannot document that what they said is true.
3. I had no ill intent in including the now infamous sidebar. I had no agenda against Fraga or even Soros. It was purely there as a part of the story, a part that I had expected to be familiar by the time of publication. It is now clear, however, that I committed a serious error of judgement in saying anything about the matter.
4. I fervently hope that this incident will not cause any difficulties either for Fraga's confirmation or for Brazil's efforts to find a way out of its economic crisis.
5. My apologies to Arminio Fraga for my carelessness.