The Free-Spending Lula

For Brazilian President Luiz Inácio Lula da Silva, 2007 has been a good year. The economy is surging, even as the United States shows signs of weakness. Rising real wages, school enrollments and life expectancy have finally nudged Brazil into the United Nations' elite of "high human development" nations. One by one Lula has seen top aides and allies fall to corruption scandals, but so far nothing seems to dim his aura. Now some of Lula's most ardent devotees in the ruling Workers Party (PT) are even pushing to change the Constitution to allow him to run for a third consecutive term in office. "All the stars are aligned," says Walter Molano, a specialist in emerging markets with BCP Securities. "He's the imperial Lula."

Sound familiar? Lula is not Hugo Chávez, of course. And unlike the Venezuelan strongman, he dismisses talk of another mandate as "absurd." And judging by his latest defeat at the hands of a rebellious Senate, which on Dec. 12 struck down a $22 billion financial transaction tax, his clout is not unlimited. But the triumphalism in Brasília is suggestive of a new and, for some, disturbing syndrome afflicting much of Latin America lately: the charisma complex. Political leaders feverish from their own popularity set out to remake their societies through sweeping referendums and constitutional changes. In its most acute form, petitions trump legislatures and vox pop speaks louder than the law. Venezuelans, for instance, have cast ballots 10 times since Chávez took office in 1999, weighing in at his behest (though not in his favor the last time) on curbing private property and infinite re-election. Rafael Correa of Ecuador and Bolivia's Evo Morales have ordered their own radical new national charters. Is a Brazilian overhaul next? Undoubtedly, Lula has charisma to burn. After five bruising years in power, 50 percent of Brazilians still rate his government "good or excellent," according to a recent survey, while the polling firm Latinobarómetro has named him the region's most popular political leader for the second year. But while no one is betting that the union man turned free-market paladin will don a red beret and fall in lockstep with the Venezuelan leader's Bolivarian revolution, troubling signs are emerging that he is backtracking.

When he took office in 2003, Lula took care to break bread with business leaders and the middle class, keep inflation low and maintain a budget surplus to placate wary investors. That strategy steadied the economy but angered the PT rank and file, who attacked Brasília for pandering to "neoliberals." A year into his second mandate, Lula appears to be wobbling. Gone are the fiscal conservatives and the champions of lean government who once had his ear. Enter the "developmentalists," led by Finance Minister Guido Mantega, who clamor for a stronger bureaucracy and greater state intervention into the market. "A part of Lula still believes in a conservative monetary policy," says former Finance minister Maílson da Nóbrega. "But there's still the old Lula that believes that government must spend, and he has surrounded himself with people who think the same way."

Waver though he might, Lula is unlikely to lurch to the left ideologically. But fiscally, the trend lines are clear. In a new study, economist Fabio Giambiagi shows that every government for the last 17 years has spent more than the previous one. Total government outlays (minus interest payments) have spiked from 14 percent of GDP in 1991 to 22 percent in 2007. Part of the blame falls to the country's Constitution, rewritten in 1988 by lawmakers so anxious to shed the manacles of the nation's long dictatorship (1964 to 1985) they stuffed the charter with perks and entitlements such as a 44-hour workweek and retirement benefits for rural workers who never paid social-security tax.

Brazilians are still paying the price. Taxpayers shell out 35 percent of their earnings, nearly double the tax burden for the rest of Latin America. Lula has bloated government further by creating thousands of patronage jobs to fill 37 ministries—16 more than he inherited from the last government and nearly double the number in the 1970s, when the free-spending military ran Brazil. He has also handed out cash stipends to some 45 million Brazilians and raised the minimum wage 55 percent in real terms. That might seem only fair in a nation with one of the most dismal income gaps in the world. But the Constitution also links the minimum wage to other entitlements, so every hike in the wage touches off a cascade of increases—in pensions, and in unemployment and disability compensation—putting even more strain on the social-security system.

The warning signs are already flashing. Though foreign debt has plunged in recent years, the government's public sector total borrowing still stands at nearly 44 percent of GDP, far higher than that of most emerging-market nations. If that does not improve, it could delay Brazil's much-acclaimed bid for investment-grade status, which would lower the cost of loans for public and private borrowers. Delay is something Brazil can ill afford. For all its big spending, the government invests less money today than it did in the 1980s, Brazil's infamous "lost decade."

If he chose to, Lula could use his celebrated charisma to push for deeper budget cuts and an aggressive agenda of political reform that could help jolt the nascent economic recovery into higher gear. Instead, say the critics, the Lula government seems oddly complacent. "There's a feel-good factor, with plenty of credit around and people traveling all over," says Brazilian political scientist Bolívar Lamounier. "But the government has no political agenda. If it weren't for China buying up Brazilian goods, we'd be lost."

Tellingly, instead of cutting public spending, Brasília dedicated much of the last few months to salvaging the financial transactions tax. Though the tax was meant to be for public health, government had come to rely on it for all sorts of contingency spending. Now with the levy set to expire at the end of December, Brasília may be forced to slash its budget anyway.

That may not be a bad thing. For a country long known as the developing world's chronic underachiever, Brazil could be missing a massive opportunity. Thanks to booming prices for commodities like soybeans and steel and a decade of stable prices, the economy is set to expand by nearly 5 percent in 2007, better than double the rate it has averaged over the last two decades. But if the international economy softens, the surge could quickly turn into another slump. Perhaps more than any other Latin American leader, Lula has the political capital to keep Brazil from stumbling. The question is: how will he spend it?