The Imperative for Financial Reform in Brazil

Good afternoon and thank you for coming out. I want to also thank the Free Brazil Movement for inviting me and congratulate them on the great work they have done.

I work on financial and economic policy for the Cato Institute in Washington, DC. As I am sure you are aware, we do not align with any particular political party. We would like to see all political parties adopt our policy proposals.

I should also emphasis that we are completely privately funded and take no money from the United States government.

My one objective this afternoon is to convince you that a freer financial system is a critical component of a free society and should be a center piece of your reform agenda here in Brazil.

Given the history of banking here in Brazil, one would be rightly skeptical of anything that appears to benefit banks. Starting in the colonial period, during the Old Republic, during military dictatorships and even during the return of democracy, banks have consistently been instruments of government policy.

I will return to this point, but my most important point today is that this need not be the case. A different, freer banking system can be an agent for positive social change.

We have already seen a number of positive changes in Brazilian banking since the 1990s.

So I do not think I need to convince of the harm that can happen when a banking system performs poorly. Let us instead think about the benefits of when a banking system performs well.

I am going to start out very general and then work towards more concrete examples.

What is most fundamental about finance is that is a bridge to the future. Finance is all about connecting today to tomorrow. Allowing us to build a bridge to some version of our future selves.

Mostly importantly it gives us some greater choice over which of our possible future selves might come into being. Imagine how much more opportunity you have if you can borrow to go to college or to buy a home. You can almost become a completely different person.

That’s the power of finance, when done right. It can also allow the same for groups, such as countries or societies.

One of the most powerful aspects of markets and finance is that they help us move social interactions from being based upon social status to being based upon contract. For most of history your family, race, religion, or gender could well determine your line of work, whether you could open or own a business, or whether you could even work at all.

Markets break that down social status, which is of course one reason many people do not like them.

To illustrate with a simple example. Let us say you have some money to invest. You have two neighbors that both come to you with investment ideals. How do you choose? Historically you might trust one because he was married to your sister or your cousin, or went to the same church. If you know nothing about the other person this might be the safest choice.

Banks often developed as a way to let you delegate the choosing to them. The bank would specialize in figuring out who was the better investment, that way you would not be at some much risk and we would also see capital flow to its most productive uses.

Banks used to build this information themselves, much of it subjective. This gave the bank some market power. Just as someone having a good family name could give them an advantage. For those of you who watch Game of Thrones, you might recall the line “a Lannister always pays his debts.” The value of having such a reputation is that people will lend to you and do so at a good rate. That can give you a real advantage over others.

But let us suppose you are not born with a famous family name. You might not be able to borrow. Not until there is the development of alternative ways of judging credit, such as with individual credit scores.

It might seem de-humanizing to be characterized as a number, a credit score, but it allows you to build your own reputation, which allows you greater choices and an ability to compete with established firms.

The point is that the development of a formal credit system allows individuals without social status to compete more directly with those who do have social status.

Now to compete, one must substitute performance for social status. That is you create a personal history of trust, of timely payment.

Which leads us to another important side effect of finance: that while finance depends to a high degree on trust, finance can also increase levels of trust by rewarding the fulfillment of obligations, ultimately increasing economic growth as well as strengthening social bonds.

By connecting present rewards with future behavior — for example, getting a loan now in exchange for paying it off over time — finance can instill trustworthy behavior on the part of borrowers.

Individuals that develop a practice of honoring their obligations in one setting, such as regularly paying their mortgage, are likely to display similar behavior in other settings, increasing overall trust.

Trust is of course an important contributor to economic growth. Or as importantly a lack of trust, in the form of low-cost contract enforcement, is an important source of underdevelopment and stagnation.

While a number of academic studies have confirmed this relationship, you can visually observe it by noticing that societies with freer financial markets display higher levels of income per capita.

Given the association of finance with capitalism, it should not be surprising that the wealthiest countries tend to be those with the most extensive financial systems. The wealthiest countries also tend to have the freest financial systems.

Poor countries, contrary to popular myth, do not suffer any lack of financial regulation. On the contrary, they tend to have extensive regulatory structures consisting of numerous restrictions, particularly on credit terms.

While the economics might seem obvious, what might be surprising is the positive association between freer financial markets and both democracy and personal freedoms.

But then this should not really be surprising, as governments that attempt to control the political and individual freedoms of their citizens also tend to control their economic freedoms as well.

The relationship, however, is not one-way. Greater market and financial freedoms allow individuals to borrow or build wealth, allowing them to challenge not only economic incumbents but also political.

If the government controls the banks however, whether you get a loan or not can depend on your willingness to support the government.

If a free financial market, you might actually be able to mortgage your house to start a political campaign to challenge the status quo. Political movements almost require money to get started. A freer financial system makes such more likely.

As I mentioned earlier, finance can be a bridge to our future selves. The same can hold for a society. One of the biggest obstacles to reform is that even if the overall society is made better off, some individuals could be worse off. Often those individuals hold positions of power and can stop reform, even at the expense of the greater society.

Here finance offers a possible solution. If the reforms will actually growth the total pie, then perhaps we can find a way to make the losers also into winners.

Let us look at the example of Japan in the nineteenth century. When the US Navy forced its way into Japan in 1853, it pushed Japanese society into a crisis, forcing that society to recognize it had fallen behind technologically and militarily. Japan needed to modernize to survive.

At the time Japan had a hereditary caste system like India’s. One caste we have all heard of is the warrior caste, the Samurai.

Only the Samurai could hold military positions. But Japan needed to quickly modernize its military. Such threaten the traditional position of the Samurai. The details are not all that important, the important part is that for Japan to survive it needed reform and that reformed would make losers of a very powerful part of society.

The solution was the creation of government chartered banking system in which the owners were predominately Samurai. As these Samurai banks would only be successful if Japan’s economy grew, it gave the former Samurai an incentive to support growth, rather than fight reform.

So while we might rightly be offended by members of society that hold elite positions and block reform, the best path forward can sometimes require financial innovations that change their incentives towards supporting reform. In a sense, you give the opposition shares in a common future.

I mentioned at the beginning of my discussion that finance can have a dark side.

Banks are often the largest single funders of governments. Subsidies for finance can reduce market discipline. Subsidies can also reduce fiscal discipline. Brazil witnessed this in the 1980s and 1990s when state banks allowed the individual Brazilian states to spend far more than they received in direct revenue. The state banks were enablers of bigger government.

Ultimately the bank-enabled spending led to the rescue of several Brazilian states in the 1990s, along with the privatization of many state banks.

Let me emphasis that I see nothing inherent in banking that results in the creation of oligarchies or monopolies or political and economic oppression.

It is when governments control and use banking for their own ends that these results arise. The solution is minimizing the dark side of finance is to first eliminate government guarantees of financial risk taking. Subject banks and borrowers to market discipline.

As importantly allow free entry into finance. Banks are only able to support governments when they have monopoly positions.

If you subject banks to competition, their ability to help entrench politicians is greatly reduced.

So if you want to increase social trust, economic growth and political freedom, one important component is to bring more freedom into your financial system. Do so with less subsidies and more competition.

I will finish my remarks with a few suggestions and observations on Brazil’s banking system. Let me first make clear I do not mean in any way to imply that finance in the United States works well or is perfect. In fact I think it is deeply flawed, but that’s a discussion for another day.

One of the biggest problems facing finance in Brazil is the difficulty in enforcing credit contracts. If I lend you money and I cannot use the legal system effectively to get you to pay me back, then I am less likely to lend you money and we are both worse off.

This a major reason that the World Bank, in its cost of doing business survey, ranks Brazil so low in the ability for households to get credit relative to comparable countries.

A big difference between comparable countries is the weakness in the legal rights of borrowers and lenders.

Fortunately Brazil does relatively fine on the sharing of credit information about borrowers. Yes there can be some improvements here but this is not the primary problem.

In many countries, businesses often get started by borrowing against one’s property. But such is only possible when title is clear. Unfortunately in Sao Paulo, it can take 14 different steps, totaling almost 30 days to get your property titled, with the cost running over 3 percent of the value of property, not including your own time working pass these steps. Obviously this makes it harder to title property and hence harder to use that property to borrow against.

It is much easier to title property in comparable countries. Let me emphasis I consider the ability to own and use property to be fundamental to a free society.

Let me take a minute to mention a reform that did improve the rights of creditors. The 2005 reforms to Brazil’s Bankruptcy law, among other things, improved the ability of creditors to collect on claims when a firm went bankrupt. This might just seem to help creditors, but the result was also to help borrowers by making lending more available.

That said, it is still difficult to resolve failing firms. And as we all know, you cannot have free markets without allowing for failure. But the absence of a predictable, reliable quick failure process for firms will reduce lending to firms, resulting in greater concentration and less competition.

I appreciate your attention today and again thank for you coming out today and all your efforts for working toward a freer Brazil and a freer World.