Brazilian Journal of Political Economy, vol. 24, nº 1 (93), January-March/2004 Escaping the Debt Constraint on Growth: A Suggested Monetary Policy for Brazil

Existing interest rates imply explosive debt dynamics for Brazil. It also faces ris-ing inflation from earlier currency depreciations, which could trigger future depre-ciation. These conditions impose a policy contradiction. Brazil needs lower interest rates for debt sustainability, but tight monetary policy to avoid exchange rate depre-ciation and inflation. The paper develops a strategy to escape this contradiction. Policy must bolster investor confidence to lower external interest rates, lower domestic in-terest rates to reduce debt service burdens, and implement domestic credit creation controls to control inflation. I. BRAZIL’S MACROECONOMIC POLICY AT A CROSSROADS Taking office in January 2003, President Lula da Silva inherited a difficult eco-nomic situation marked by great uncertainty following the financial crisis of 2002. Fortunately, in the first six months of the new president’s term, financial markets have responded positively. The Real has rebounded from its crisis overshoot, and the strength of Brazil’s currency and stock market is being interpreted as a sign that current macroeconomic policy is working. To some, the implication is that Brazil only needs to stay the course with its existing regime of tight money. This paper argues that this position is mistaken, and that the existing policy configuration cannot achieve economic growth. At best, it can ensure financial sta-bility. However, more likely, it will result in stagnation that is ultimately joined by renewed financial crisis. Instead, Brazil must adopt a new monetary policy mix that enables it to escape the debt constraint on growth. Analytically, this constraint can be understood through the highly indebted developing country trilemma which ha