Brazilian Sclerosis

Sclerosis is a term that refers to an anomalous stiffening of organic structures: from the liver to the arteries, muscles to kidneys, unemployment to investment. In 1986, Olivier Blanchard and Lawrence Summers coined the term "Eurosclerosis" to describe the persistent unemployment in Europe, which seemed never to return to the levels that preceded recessionary cycles. A modernized interpretation of the term suggests that the Brazilian economy is suffering from sclerosis: The hardened structure is investment.

In chapter 3 of the recently released World Economic Outlook, the International Monetary Fund (IMF) breaks down the evolution of potential GDP in advanced and emerging economies, a subject that I discussed in a recent article about Brazil. Potential GDP, for those unfamiliar with the term, is a theoretical construct that indicates how much an economy is able to grow without generating inflationary pressures by efficiently employing and utilizing all resources at its disposal: from technology to the workforce, from the stock of productive capital to the volume of human capital. The debate on potential GDP is once again prevalent in international policy circles, as some prominent economists have come out in favor of the secular stagnation hypothesis. The idea is not new; its first version appeared in 1938. According to the modernized version, secular stagnation is associated with an economy's inability to achieve full employment and restore potential growth in the absence of negative real interest rates. That is, in order for there to be secular stagnation, growth needs to be anemic, investment has to be "insufficient" by some measure of what would otherwise be desirable, inflation needs to be low and/or close to setting off deflationary spirals, and the real interest rate has to be in negative territory.

The idea of secular stagnation is thus compatible with the notion that investment is systematically insufficient to rescue the growth potential of an economy. Viewed in this way, the thesis seems to suit Brazil. Of course Brazilian inflation is at an all-time high of 8.1 percent over the last 12 months, way beyond the target ceiling of 6.5 percent. Moreover, Brazil's real interest rates are among the world's highest and are likely to increase further as the central bank tightens monetary policy to fight off inflationary pressures. Thus, even if one believes in the secular stagnation argument—and there are many who would disagree with the premise for a host of valid reasons, myself included—it doesn't appear to apply to Brazil.

If inflation and interest rates do not fit the secular stagnation hypothesis, low growth and the apparent decline in potential GDP suggest that something is indeed very wrong with the Brazilian economy, something that transcends the macroeconomic mismanagement associated with President Dilma Rousseff's first four years in office. This does not seem to be something that could be resolved by implementing the current fiscal adjustment, as much as one may admire Finance Minister Joaquim Levy's efforts.

The evidence suggests that Brazilian investment is sclerotic, like European unemployment during the 1980s and 1990s. According to the latest National Accounts data, Brazilian investment rates over the last 20 years have barely budged from 19 percent of GDP. Recessions have come and gone, and investment has simply stood still. Interestingly, when one analyzes the behavior of the relative price of investment—that is, the price of investment relative to that of other goods and services produced in Brazil—one can readily see that it has been falling sharply and steadily since 2009. For a given supply of investment, roughly measured as the production of capital goods, this would reflect a drop in investment demand by firms. However, there is ample evidence to suggest that investment supply has also fallen since 2009, in which case either demand has fallen even further to justify the behavior of relative prices, or inflation of other goods and services have vastly outpaced the investment deflator. In this latter case, a fall in the relative price of investment should have created the conditions for improvements in demand, restoring the equilibrium at a higher investment rate. But investment demand in Brazil seems to be at best inert, and at worst falling by more than investment supply.

How should we think about solving Brazilian sclerosis? How can we avoid this uniquely tropical version of "secular stagnation," loosely defined? This is a question that has remained unanswered for far too long.