More Lessons from Brazil’s Boom-Bust: The “Populist Paradigm” Revisited

The current discussion over the rise of “economic populism” in advanced economies could benefit from a look at a Latin American classic, The Macroeconomics of Populism in Latin America, edited by Rudiger Dornbusch and Sebastian Edwards. Published in 1991, the book still offers many compelling insights into the workings of so-called “populist” macroeconomic policies. An analysis of Brazil’s recent experience, and the origins of its current deep economic crisis, provides useful lessons on what could be dubbed a modernized version of Dornbusch and Edwards’ “populist paradigm.”

As laid out by the authors 25 years ago, the “populist paradigm” can be summarized by a series of features and characteristic phases. Below is a modified, modernized version of the original paradigm, based on the Brazilian experience.

Features

1. Initial conditions: Policymakers and the population at large are deeply dissatisfied with the economy’s performance. Grave income distribution disparities provide the appeal for a radically different economic program.
2. No constraints: Policymakers reject the notion of constraints on macroeconomic policy—government budget constraints are often ignored on the premise that if the public sector is able to induce growth, constraints become less binding over time. Idle capacity is seen as providing a leeway for expansion. International reserves provide an additional rationale for expansion since they mitigate the risk of balance-of-payments problems arising from runaway budget deficits. According to the authors, “the risks of deficit finance emphasized in traditional thinking are portrayed as exaggerated or altogether unfounded. According to populist policymakers, expansion is not inflationary (if there is no devaluation) because spare capacity and decreasing long-run costs contain cost pressures and there is always room to squeeze profit margins by price controls.”
3. Policy prescriptions: Policies focus on actively using macroeconomic policies to redistribute income, boost growth, and “restructure the economy.” “Restructuring the economy” may be a vague, unsubstantiated statement, or it may be formulated around a broad concept of “promoting development,” which often means promoting the local manufacturing sector through a combination of protectionism, credit policies, and targeted fiscal policies.

Phases

1. Vindication: Policy prescriptions deliver the expected outcome. The economy grows faster, real wages climb, and unemployment falls. The economic boom may initially produce an appreciation of the exchange rate that serves to offset mounting inflationary pressures. Relatively cheaper imports accommodate expanding demand. Credit availability at favorable conditions—prolonged maturity and/or cheaper borrowing—stimulates indebtedness. The initial boom sets off a cycle of overleveraging and decreased risk aversion for the public and private sectors.
2. Constraints become binding: Budget deficits widen considerably, as do current account deficits. Inflationary pressures can no longer be contained by exchange rate appreciation. As risks increase, the exchange rate may reverse course and devalue, stoking inflation. Growth decelerates.
3. Disarray: Economic populism begets economic populism. Policymakers may opt to double down on policy prescriptions in order to attain “vindication” once again. Doubling down accelerates inflation, which may induce temptations to impose temporary price controls, further damaging the economy. Budget problems worsen, the debt-to-GDP ratio rises to unsustainable levels, growth falters, and the country may tip into recession due to macroeconomic uncertainty and instability. Excessive debt built up during the vindication phase ultimately takes a toll on consumption and investment.
4. Orthodoxy: The return to orthodox stabilization becomes inevitable, with deep, procyclical fiscal and monetary adjustments. As Dornbusch and Edwards eloquently write, “when all is said and done, the real wage will have declined massively, and that decline will be very persistent, because the politics and economics of the experience will have depressed investment.” The investment slump is made worse if balance sheets are significantly damaged.

Brazil’s recent experience has all the features of the “populist paradigm” described above. Notably, the government not only closely followed the typical policies associated with “economic populism,” but under the second Lula administration and the first Rousseff administration it attempted to “restructure the economy” by directly interfering in markets—introducing sector-specific tax breaks to induce local job creation and investment in domestic manufacturing, among other interventionist initiatives. Moreover, Brazil also went through all of the detailed phases. Currently, the country is deeply overleveraged. Public sector debt is hovering at 74 percent of GDP, and will likely climb to more than 80 percent in the next two years. Subnational finances are in tatters, with several states on the verge of bankruptcy. The corporate sector is weighed down by excessive debt, and bankruptcy applications have risen almost threefold over the past 18 months. Households owe 45 percent of their disposable income, and debt service obligations consume more than 20 percent of their monthly income flows. The government, however, has refused to recognize these profound balance sheet problems.

The government should be commended for guaranteeing approval of a constitutional amendment limiting expenditure growth at the federal level. However, this will only begin to dent the debt-to-GDP trajectory some five years from now, assuming that a contentious and complementary social security reform is approved by a largely discredited Congress, mired in corruption allegations. Meanwhile, the Finance Ministry has resisted calls for measures that ease the debt burdens of households and companies, insisting that reforms will instill confidence, bringing back consumption and investment flows. The confidence game, however, is not possible if balance sheets are in tatters. The reason is simple enough: When companies and households are overleveraged, their main concern is reducing debt, not increasing consumption or investment.

The incoming US administration appears to be flirting with some elements of the so-called populist paradigm. President-elect Donald Trump has shown a degree of disregard for macroeconomic constraints by defending aggressive expansionary fiscal policies, as well as by signaling intent to interfere in market decisions—the recent deal with Carrier is one such example. It is too soon to say whether the approach to Carrier embodies a deeper belief that the government can improve market outcomes by deciding which sectors must expand. We may soon know whether the incoming president is a “secular stagnation buster” or an economic populist avid for his vindication phase, which markets seem to be already pricing in.

One should nonetheless keep in mind that the United States has just recovered from a severe crisis of overleveraging. Its new leaders would therefore be well-advised to analyze the depth of Brazil’s current problems.