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Central Bank or Treasury Department -- Who is responsible for the current surge in prices in Brazil?


Central Bank or Treasury Department -- Who is responsible for the current surge in prices in Brazil?

In reading the economics section of the most prominent newspapers and magazines of the country, any one possessing a minimal understanding of economics will inevitably feel as if they are being thrown into a world that could have been created by Frank Kafka, once the reader sees himself in a situation which he is being confronted by a beast that seems blind, deaf and completely impermeable to any common sense and economic rationality. Commenting on the recent surge in prices in Brazil -- in March, the 12-month IPCA (consumer price index) reached 6.30% -, the media opted for a Manicheist approach that made no economic sense: in one side we have the Ministério da Fazenda (Treasury Department) and the always barmy Guido Mantega, continuously messing with the budget, spending money to keep the "aggregate demand" churning and granting hefty subsidies from the BNDES (Brazilian Development Bank) to his favorite companies.  This is the dark side of the battle.  On the other side, representing common sense and dignity, is the Banco Central (Central Bank), under the fearless leadership of a rational and competent Alexander Tombini, who is always supported by the loyal legions of the COPOM (Monetary Policy Committee), tethers a quixotic fight against the dreadful Mantega and his inflationary tumbleweeds which permeate through out the Brazilian economy.

Translation:  The media blames the recent price hikes in Brazil on the uncontrollable spending of the Ministério da Fazenda (Treasury Department).  In order to restrain this frivolous expenditure, the Banco Central (Central Bank), always active and vigilant, would be immolating its popularity in an inglorious fight with the intrepid Guido Mantega, by raising interest rates to counter the surge in prices caused by the spendthrift "manteguistas", sacrificing the popularity of the institution and the Government itself -- all for the good of the country.

Government Spending

At first glance, the media's stance on this issue seems to make some sense.  After all, Government expenses do in fact provoke price inflation.  When Government spends, it is consuming goods which would have otherwise been utilized by the private sector or entrepreneurs towards more productive and useful means.  Goods that would be available to the population end up being consumed by the Government.  Consequently, Government spending reduces the amount of resources available to the population.

If Government spent less,

1)      There would be a higher amount of goods available to consumers who need them with more urgency than the Government;

2)      Industries would not need to employ resources only to supply the scarcity of such goods (a scarcity caused by the Government), instead permitting investments in new methods of production resulting in a larger abundance of goods available;

Therefore, Government spending makes it that less of these goods are made available to the private sector, raising their costs and, consequently, harming the poor.  Government spending also forces industries to reallocate their resources towards the production of those goods consumed by Government, impeding the investment in, and the expansion of, other production processes.  In the end, the expenses of the Government also impede that these goods consumed be employed towards more productive means by the private sector, which could also generate benefits to other parties.

It is soon clear that Government spending inevitably stimulates price inflation and all condemnation towards this action will always be welcomed.

Nevertheless, there exists a small problem; this is where the media gets lost.  The rise in Government spending is only possible via the existence of a Central Bank which may create money out of thin air.  Absent a Central Bank, it would be impossible for Government to raise its spending continuously, as does the Brazilian Government.  Therefore, the Brazilian Central Bank, instead of being a warrior against price inflation and the senselessness of the Ministério Da Fazenda (Treasury Department), is above all its purveyor and protector.  The Ministério Da Fazenda (Treasury Department) can only spend disproportionately due to the existence of a Central Bank.  It is soon apparent that the onus lies on the Central Bank and not the Treasury Department for the recent surge in prices in Brazil.

Guido Mantega

Prior to explaining the reasons behind the culpability of the Central Bank, we will have a short commentary on Guido Mantega.

In early December of last year, I wrote a small passage on our blog commenting on the inexplicable respect enjoyed by Guido Mantega with the press.  It did not matter what absurdities were said by the man ("Inflation is under control and will not exceed our target"), the media's subservience to his statements was always present, conferring in him areas of great knowledge to the nonsense which he uttered ("We can remain calm as a reduction in food prices will occur in the beginning of 2011.  We have seen this story play out before").

A prominent magazine, touted as oppositionist, has even glorified him as a "great captain" steering the economy into a new era of "responsible social development" created by the Lula administration, a healthy and necessary change in relation to the "insensitive social austerity" of the Palocci era.  No criticisms were directed towards this distinguished gentleman, Guido Mantega.

Apparently, anyone can be exalted when times are good.  The moment that the ship begins to take on water all reverence is removed and all fingers are pointed towards the captain, accusing him of conducting the embarkation in an imprudent manner during the entire voyage -- he, who was always seen as the great beacon of temperament and modernity.

This shift in posture, despite all of this, is great news.  A nation can only aspire to obtain integrity when its men of public office become discredited by the media.  It is however easy to vilify Guido Mantega, despite his natural astuteness, he possesses a physique du role for such criticisms.  Precisely for lacking an understanding of what is happening in the economy, his ignorance and deer-in-the-headlights look on his face is in itself a grotesque spectacle.  He may be inept, but is otherwise not guilty.  The real revolution will occur on the day in which the truly guilty party -- the bureaucrats running the Central Bank -- receive the same harsh criticism.

Why the Central Bank is pernicious

If you open up any Macroeconomics textbook, you will learn that the function a Central Bank provides to a country is a safe, flexible and stable financial and monetary system -- or a similar explanation.

However, such an explanation is not only false, but the complete opposite of reality.  In other articles of this site, the fact that the monetary supply of an economy does not need to be either manipulated or altered has already been discussed.  Money is simply a medium of exchange which facilitates indirect transactions.  A higher quantity will simply dilute prices and redistribute the income in favor of those people or companies which are the first recipients of this new money.  There is no set quantity which to follow, any quantity works in the long run.

Understanding the above, let's clarify the real function of the Central Bank, the one not found in university approved textbooks.

The Central Bank -- being in Brazil, USA, EU, Chile or in Australia -- possesses two major functions:

1)      Protecting the banks -- forming a banking cartel that discourages competition -- and bailing them out in times of financial insolvency; and

2)      Finance the Government's deficits

Item number one is the easiest to comprehend.  The banks operate on fractional reserves, which essentially means they loan more money than what was deposited in their vaults.  In other words, banks have the power to create money.  This money created by the banks out of thin air -- a digitization of money, for which there exists no corresponding amount in paper or physical coins -- is called fiduciary media.  It is this which is utilized as payment through checks or debit cars, but it does not possess a corresponding value in physical money inside of the bank's coffers.

In this fractional reserve scenario, in the absence of a Central Bank, there would exist the risk of an uncoordinated expansion of credit.  The most expansionist banks -- those who created the most money -- run the risk of losing reserves to the less expansionist banks. If Itau creates more fictitious money than Bradesco, the fiduciary media of Itau will inevitably fall into the account of a Bradesco member.  If this persists, Bradesco will request, at the end of the day, that Itau make good on the amount credited, sending a corresponding amount in money (in this instance, paper or metal coins), resulting in a loss of reserves for Itau.  In the extreme case that Itau enormously expanded its credit and Bradesco had adopted a more conservative posture, Itau could completely be wiped of its reserves, going into bankruptcy.

It is at this precise point where the Central Bank comes in.  It can "supervise and control" the credit expansion -- plainly, harmonize the expansion, making it so that all banks create new money at the same rate.  If all banks expand credit at the same rate, the risk of bankruptcy will not materialize because one bank created more money than another.  When all banks simultaneously expand credit, the amount of fiduciary media of Bank A that ends up in Bank B's account is practically the same that goes from B to A, such that during settlement, they cancel each other out.  Such an arrangement permits that banks maintain less money in their reserves than they otherwise would in case there was no Central Bank.  In other words, this arrangement increases the capacity of banks to create money out of nothing, consequently raising their profits.  This results in high profits without the risk of insolvency.

Therefore banks vehemently defend the existence of a Central Bank.  It is the Central Bank that forms and coordinates this cartel, creating a barrier to entry for competing banks that could affect this delicate equilibrium.  Without a Central Bank, there would be no coordinated expansion of credit, for there would always be the risk of one bank leaving the cartel and demanding its compensation of fiduciary media, and with that, sending its competitors to bankruptcy.  In order to have any coordination, banks must form a cartel.  To coordinate this cartel, to discipline "rebel" banks, a Central Bank is necessary.

Ergo, a Central Bank allows banks to expand their credit without the risk of insolvency, excessively raising the profits of this sector.  As an additional benefit: in case there is a bank run, or a bank becomes insolvent because it engaged in bad loans, the Central Bank can create money to bail it out.  This guarantee stimulates banks to expand their credit ever more, thus generating economic cycles.

However, this still is not the principal function of a Central Bank.  Up to this point we have only been discussing the relationship between banks and the Central Bank.  Nevertheless, the Central Bank is a Government entity.  It is soon apparent that its primary function is to tend to the immediate interests of the Government.  This is exactly what happens.

You will seldom hear this from the mouths of academic economists, for this is the reality:  The Central Bank exists primarily to finance Government deficits.

Nonetheless, this scheme is not so obvious at face value.  The Central Bank does not simply create money and funnel it directly to the Government.  In truth, this occurred until the mid 1990s.  During that period, the Government sent the Congress a proposal requesting authorization for the Central Bank to print a determined amount of money to cover the budget deficit.  And Congress always approves this request.  It was that simple:  The Government collected $1,000 in taxes, but wanted to spend $2,000.  What was the solution?  Print the difference.  After price inflation reached a few billion percent, the geniuses finally woke up to reality.  In 2000, with the Fiscal Responsibility Law, this type of direct financing was prohibited.

Today, the Central Bank does not print money and deliver it directly to the Treasury.  Even though in practice this is exactly what the Central Bank continues to do, it is now done in an indirect manner.  This is the ingenious trick which no one takes into account.

It works like this:  when the Central Bank wants to expand the monetary base, it needs to engage in what is referred to as open market operations -- which is, the Central Bank purchases Government Bonds which are held by other banks.  Explicitly stated, the Central Bank creates money to purchase these bonds that are held by the banking system.  Currently, this is the only legal manner in which the Central Bank creates money.

How does the Central Bank do this?  Crudely, it presses a button in a computer and adds a few digits to the account (the required reserves) of the bank that is selling the bonds it possesses together with the Central Bank.  Where does this money come from?  It came from nowhere.  The Central Bank created it out of thin air.  No other account was debited.  The monetary base magically expanded; the reserves of this bank increased.

Now, imagine that you are a banker.  You, due to fractional reserves, can create money out of nothing and utilize it for a particular investment.  You also know that the manner with which the Central Bank creates money is through Government Bond purchases which are in its possession.  It is not necessary to be a financial genius to realize that the most obvious and safest investment which you can make is precisely to purchase the Bonds which the Treasury puts up for auction.  In other words, you happily finance the Government deficit, because you are well aware that these Treasury Bills which you will purchase from the Treasury will later be bought by the Central Bank, for it is how its monetary policy functions.

In precisely knowing that these Treasury Bills will be bought by the Central Bank -- which means that they possess a high-liquidity re-sale market --, that banks merrily finance the Government deficit.  In other words, that which was directly done before -- with the Central Bank giving money directly to the Treasury -, is now done indirectly, with a caveat:  now banks are a part of this arrangement and profit enormously from it.

The arrangement seems scandalous, and it is.  However, since only a few people understand it, no one makes a fuss about it.  In the meantime, in the USA, things are becoming different.  With the financial crisis of 2008, the ridiculously large bail out packages given to the banks, and the subsequent widespread popularization of the ideas of the Austrian School of Economics, which condemns these actions, the people there are finally starting to understand this arrangement, and the Federal Reserve in under constant attack and criticism at the moment.  Never before has a Chairman of the Fed been the target of so much mockery as Ben Bernanke, and there currently exists a civil movement calling for the abolition of the Fed.  One day, we will reach that point here.

Therefore, it is worth repeating the conclusions of this section:  the Central Bank possesses two functions:  cartelize the banking system, safe-guarding it from competition and guaranteeing high profits, and finance the Government deficits -- this being its principal function.  The Central Bank does not directly give money to the Treasury, but guarantees that it will buy the bonds which are in possession of these banks.  In this manner not only does the Central Bank stimulate the financing of Government deficits, but it also encourages wreck less spending.

This brings us to our final section.

Why the Central Bank is more pernicious than the Treasury Department

It is not the intention of this article, as stated in the beginning, to pardon Guido Mantega of anything.  Government spending should always be condemned regardless of the occasion, for they destroy resources and in fact generate price inflation.  Therefore, in the absence of a Central Bank to finance these expenses, it would be impossible for there to be a steady rise in prices as it is happening now.  Ergo, the real guilty parties ought to be exposed.

The current price inflation in the Brazilian economy is mainly attributed to the expansion of the monetary supply, caused by the Central Bank.  One of the causers of this expansion of the monetary supply is the Treasury Department, as it will be shown below.  All the pertinent details of how the expansion of the monetary supply generates inflation have been exposed in this article, in a manner which does not need repeating.  The intent here is to show why, without the Central Bank, Guido Mantega would be incapable of maintaining his spending binge.

When Guido Mantega decides to spend more than the Government collects in taxes -- which is exactly what he has been doing, given that the Government is incurring consequent nominal deficits -, the Treasury sells Bonds to collect money to cover this deficit.  In the same way, when Mantega decides that the BDNES should give subsidies to the Government's favorite companies, the Treasury sells Bonds to collect money to be distributed to the BNDES, which will then re-distribute it accordingly to the related enterprises.

The below chart represents the jump in the public debt -- total Bonds sold by the Treasury to finance Government Spending -- since 2009, rising no less than R$ 600 billion in only 2 years.

cewolf (1).png

 And just what is the consequence of all this?  This rise in the sale of Bonds signifies a rise in the Government's demand for more money from the banking sector -- which, as aforementioned, merrily finances this party.  With more money flowing to the Government, the baking sector ends up with less available for loans to the private sector.  Additionally, this also makes it so that the amount of available money for the interbank market (where the banks loan to each other with the sole intent of maintaining their reserves at levels stipulated by the BACEN (Central Bank of Brazil)) remains smaller, for now there is money being demanded from all sides (Public and Private Sectors).

In this scenario, in case the Central Bank did nothing, the tendency would be that the interbank market's interest rates would rise considerably.  And the interbank market's interest rate, as it is known, is nothing more than the SELIC (Special System of Clearance and Custody).  Seeing as if the BACEN works directly with the SELIC towards a target rate, it cannot allow for rates to rise.  Consequently, it has to inject money in the interbank market just to prevent rates from rising too much.

In other words:  on one hand, the Government borrows money from the banks, which tends to raise the SELIC; and on the other, the Central Bank injects money into the banks, to prevent the SELIC from rising.  This is the way it works.

In some months past, the Central Bank injected a quantity that was sufficient enough to prevent rates from rising too much.  Today it has to inject an even greater amount just to maintain the rate within the stipulated target (currently set at 12%).

And just like that we arrive at the current phenomenon: The Government, incurring huge costs, is each time absorbing more money from the banking sector, which puts pressure on the SELIC.  Consequently, the Central Bank has to continuously inject money into the banking system just to prevent the SELIC from rising.  If it had not done anything, the SELIC would have been rising for a long time now.

Hereupon, Guido Mantega, in raising the amount of money which the Treasury borrows together with banks to finance its expenses, is provoking and expansion of the monetary supply.  Therefore, the one entity which is allowing for this expansion is precisely the Central Bank.  If the Central Bank ceased to print money and allowed the SELIC to fluctuate according to the supply and demand of money in the banking sector, as soon as the Treasury sold Bonds to the baking system, the quantity of available money in the interbank market would be reduced -- immediately raising the SELIC.  If it were to continue with this behavior, the interest on servicing the debt would be astronomical and the Treasury would simply not be able to maintain this type of financing.  There would not be enough money to satisfy the wishes of the Treasury Department.

That is, everything that the Central Bank needs to do is to cease printing money and, consequently, stop fixing the target for the SELIC.  In doing so, Guido Mantega would immediately be unable to continue his party.  All that Alexandre Tombini needs to do is to publicly denounce the Treasury Department's actions.  The fact that he does not do this only shows that not only is he evading his obligation as the "guardian of the currency" (with large doses of irony), but also fomenting its own destruction.


Therefore, to conclude:  the Treasury Department's behavior is the cause of all monetary inflation -- and, consequently, price inflation.  Nevertheless, such behavior only occurs with the complete acquiescence of the Central Bank -- the entity that facilitates this entire mess.  Curiously enough, the press does not broach the subject in such a manner.  It instead paints a picture of a villain and a hero, when in truth there are only two villains happily working in collusion with one another.

In theory, all that is necessary is for the Central Bank to turn off its printing presses and Mantega becomes powerless.  However, this is not in the best interests of either the Government or the banks.  There is nothing that can be done while this goes on.

Merely protect your savings.  The purchasing power of your money is being transferred to the Government, to the banks and protected companies.

Translated by David Klein

Sobre o autor

Leandro Roque

Leandro Roque é editor e tradutor do site do Instituto Ludwig von Mises Brasil.

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