Brazil’s Inflation Lessons

Want to learn about inflation? Ask a Brazilian.

From 1964 to 1994, Brazil had an average annual inflation rate of over 160%. Worse, that rate fluctuated drastically—from less than 1% per month, to more than 1% per day!

How was it possible for people to plan their economic activities if prices were constantly changing that much, in unpredictable ways? How was it possible for a contractor to give you an estimate about a service to be done in two months’ time if prices could vary, or not, say, 20% in that period? How was it possible for people to put food on their tables if the real value of their wages was always at risk of being eroded by price increases of some unknown magnitude? Inflation didn’t go away after 1994, but the 5-6% inflation that Brazil has seen since pales in comparison to these three decades.

Still, during all those thirty years, there was not only capital accumulation and population growth in the country, but increase in income per capita in real terms. How is this possible, given that the recent surge in inflation here in the United States to about 8% in the last year is causing so much disruption?

The answer is that Brazilians learned, the hard way, how to cope with inflation.

The late American economist John Exter (1910-2006) once observed that “the simplest clerk in Brazil understands money better than the American businessman.” There is more than a grain of truth in that.

In a market economy, prices are moving relative to one another all the time, but if the supply of money is kept reasonably stable, the general price level will remain similarly stable as well. Change in relative prices occurs due to changes in fashion for some goods and services. It may also be caused by real constraints on the supply of certain goods, such as a failed crop in a certain region, or trade disruptions caused by political instability.

Change in the general level of prices, what we call popularly “inflation” is caused by change in the money supply that puts the stock of money out of sync with the availability of goods in the economy, the famous “too many bills chasing too few goods.”

When an economy is going through an inflationary period, market movements continue to happen, but it becomes much harder for the economic agents to understand if the price signals that they are receiving from the market are “real” changes in the demand or supply of certain goods, or whether they are caused by monetary inflation. If customers are willing to pay more for some wares in the middle of an inflationary bout, how is a shopkeeper supposed to know whether that is caused because of a sudden change in the desire for his goods or because some people simply have more money in their pockets than before?

The short answer is that he cannot.

That brings us to one of the most important insights about inflation: if it is already difficult to perceive the constant real changes going on in the market even with a reasonably stable price level, it becomes even more so in the middle of an inflationary process, to the point of becoming impossible.

All that the economic agents have to make their economic calculations on are the signs about the relative market conditions for different goods and services in real terms given to them by the price mechanism. When they lose sight of those signals, they lose the conditions to act rationally.

To cope with the dis-coordinating effects of inflation that existed prior to 1964, Brazil, in that year adopted the process of “indexation.” The process gained that name because a number of prices in the economy were legally allowed to be quoted not in the local currency, but in a price “index.”

The theory behind indexation is one that separates monetary functions—that is, it uses one instrument, the currency, as a medium of exchange, and another, the “index” as the unit of account.

This process is evidenced here in the United States in the “Cost of Living Adjustment” or “COLA,” paid, for example, to beneficiaries of Social Security. For the year 2022 it will be 5.9%, meaning that for every $100 a pensioner received in 2021, he or she will receive this year $105.90 and with that his or her purchasing power will be preserved.

Like in Brazil, the COLA in the United States is calculated by a price index, specifically, the “Consumer Price Index for Urban Wage Earners” or CPI-W. It is one of a myriad of different price indexes calculated in order to show the value in constant terms of certain goods and services, in this case, the real purchasing power of wages.

Thanks to the utilization of price indexes to denominate some contracts, such as rents and employment relations, some of the “fog” blurring the information given by market prices during inflationary periods is dissipated.

It was thanks to the indexation that Brazilians were able to contract with one another and remain productive even in face of the total destruction of the value of their currency by the unscrupulous government they had during those years.

From obvious long-term obligations, such as mortgages and rents, to spot transactions, such as a taxi ride, to labor relations—any economic relationships in which people have an expectation of continuity—practically all contracts would have their prices adjusted with a reference to a price index. The monthly payments of your mortgage or rent would be adjusted every month according to some index, your wage would be adjusted also every month according to another index. Groceries and services, like a taxi ride or a haircut, would have their prices adjusted at certain intervals by their providers using as a reference yet other price indexes.

Although those price indexes in the long term tended to converge, there were seasonal variations, and adjustments to changes in relative prices. However, for the purposes of allowing economic calculation to happen, they were “good enough.”

Now, what lessons we can learn from the Brazilian experience of coping with high inflation for the current inflationary process we are experiencing in the United States?

Indexation, or “Cost of Living Adjustments” clauses in contracts are until now relatively rare in the United States. Basically they are the privilege of certain constituencies politically powerful, such as Social Security pensioners, and certain landlords who own extremely desired rental properties, such as prime shopping malls and the like.

Inflation is a process caused by the government, by the entity that monopolistically has the prerogative to create money. It is not a process created by the market.

In the United States today, these contractual clauses “automatically” adjusting certain obligations, such as pensions or rents, serve as a “claim of labor” or an exercise of monopolistic power to extract a hard bargain from some tenants. But they are, more essentially, a way to make rational economic calculations in face of uncertainty. To adopt “cost of living adjustments,” that is to make economic calculations about what you need to pay your suppliers and employees, and about what you need to charge your customers is an exercise of practical wisdom in face of an inflationary process.

If prices are going up, it is obvious that someone has more money in their pockets and is spending it.

That is another important insight about inflation: inflation is substantially a process of income redistribution. The government has the monopoly to create money and it uses that money to pay some constituencies ahead of the general public, be that its suppliers or other economic sectors favored by whoever is in charge at that moment.

In the middle of an inflationary period, the competitive nature of commercial relationships is exacerbated by the redistributive process put in motion through monetary inflation. Think about the relative share of labor costs in a given product. Employers are trying to keep for themselves the greatest part possible of the gains of productivity that all businesses are constantly aiming to achieve. Employees are trying to do the same. Given the fact that gains of productivity are incrementally low, most of the time, we are talking about 1% or 2% per year to be negotiated. Now, add inflation of 10% in a given year to the mix. With that simply keeping wages constant in nominal terms would mean a pay cut of 10% in real terms. The same thing with the rents and other expenses. The need to renegotiate prices increases exponentially. That is one of the ways in which inflation leads to economic dis-coordination.  

If determined sectors in the economy naively, and mistakenly, decide to “do their part” and not increase their prices in order to adjust to changes in the cost of living, those sectors are basically reducing the income share of their suppliers and employees—not to mention their own.

Those sectors will be losing ground, and instead of helping to solve the problem, they will be actually aggravating it, by increasing the dis-coordinating effects of inflation.

Their employees and suppliers are being invited to find other employers and customers, at the same time that by not adjusting the prices of their products, those hypothetical sectors committed to “doing their part” will consume the capital entrusted to them by their investors, creating even more problems for themselves.

Inflation is a process caused by the government, by the entity that monopolistically has the prerogative to create money. It is not a process created by the market. In Brazil, the hyper-inflationary process was only put under “control” once a modicum of fiscal responsibility was introduced in the management of the Federal and State governments, but that is a topic for another time.

The solution to the problem of inflation is therefore political: it depends on individuals in their capacity as citizens demanding government restore a minimum of fiscal responsibility, and provide for an economic environment that, at least, is not hostile to production.

It depends on the individuals in their capacity as economic agents only secondarily. As economic agents, the best the individuals can do is to try to keep the relative prices more or less constant in real terms by adjusting them to the cost of living. They should do that in order not to disrupt economic coordination even further, to the extent that prudence recommends, in face of increased distributive tensions. That is the best they can do for themselves, and in the end, for the country until economic and political reality jolts politicians out of their profligate ways.