Vitor Mello, Author at

The Neoliberal Tale

“The tide of Totalitarianism which we have to counter is an international phenomenon and the liberal renaissance which is needed to meet it and of which first signs can be discerned here and there will have little chance of success unless its forces can join and succeed in making the people of all the countries of the Western World aware of what is at stake.” (Friedrich Hayek)

In the past year we’ve seen a number of mentions to the maladies that neoliberalism and globalization have brought upon Western societies (e.g., see here, here, and here). It is well known that during the past decades the levels of inequality and wealth concentration have continued to increase in capitalist economies, leading to the arrival of “outsiders” to the established political powers such as Trump in the US and Macron in France, a turn to the right all over Latin America, and Brexit.

Neoliberalism, one of the main elements to blame, is better known for the policies that defined the world economy since the 1970s. Faithful devotees like Ronald Reagan and Margaret Thatcher, in the US and UK respectively, exported a number of their neoliberal policies to low and middle income countries through the Washington Consensus under the pretense that it would bring about development.

Neoliberal policies did not exactly turn out the way their creators envisioned. They wanted to reformulate the old liberal ideas of the 19^th century in a deeper and coherent social philosophy – something that was actually never accomplished. This article will review some of the origins of neoliberalism.

The first time the term “neoliberalism” appeared, according to Horn and Mirowski (2009), was at the Colloque Walter Lippmann in Paris, in 1938. The Colloque was organized to debate the ideas presented in Lippmann’s recent book The Good Society in which he proposed an outline for government intervention in the economy, establishing the boundaries between laissez-faire – a mark of the old liberalism – and state interventionism.

Lippmann set the foundations for a renovation of the liberal philosophy and the Colloque was a first opportunity to discuss the classical liberal ideas and to first draw a line in what the new liberal movement would or should differ from the old liberalism. It was a landmark that, in subsequent years, sparked several attempts to establish institutions that would reshape liberalism, such as the Free Market Study at the University of Chicago and Friedrich Hayek’s Mont Pelerin Society (MPS).

This event announced major difficulties among the peers of liberalism. Reservations and disagreements among free market advocates were not uncommon. A notable mention is Henry Simons, of the Chicago School, whose position against monopolies and how they should be addressed was a point of disagreement with fellow libertarians such as Hayek, Lionel Robbins – both at the London School of Economics (LSE) at the time – and Ludwig von Mises.

Simons’s view that the government should nationalize and dismantle monopolies would nowadays be viewed as a leftist attack on corporations but it fits perfectly under the classical liberal basis that Simons and Frank Knight, also from the University of Chicago, were following. Under their interpretation, any concentration of power that undermines the price system and therefore threatens market – and political, individual – freedoms should be countered, even if it meant using the government for that purpose.

It becomes clear that the reformulation of liberal ideas into what we know today as neoliberalism was not a smooth and certain project. In fact, market advocates struggled to make themselves heard in a world guarded by state interventionism that dominated the Great Depression and post-war period. Keynes’s publication of The General Theory in 1936 and the wake of the Keynesian revolution, swiped economic departments all over and further undermined the libertarian view.

By the end of the 1930s and of Lippmann’s Colloque, however, the perception that neoliberalism would only thrive if there were a concerted collective effort by its representatives changed Hayek’s perception over his engagement in the normative discourse. In 1946-47, the establishment of the Chicago School and the MPS, were both results of a transnational effort to shape public policy and fit liberal ideas under a broader social philosophy. The main protagonists beyond Hayek were Simons, Aaron Director, and the liberal-conservative Harold Luhnow, then director of the William Volker Fund and responsible for devoting funds to the projects.

The condition for success, as remarked in the epigraph, was to “join and succeed in making the people of all the countries of the Western World aware of what is at stake.” What was at stake? Social and political freedom. Hayek and many early neoliberals understood that any social philosophy or praxis crippling market mechanisms would invariably lead to a “slippery slope” towards totalitarianism.

It is important to note, though, that the causation runs from market to social and political freedom and not the other way around. As Burgin (2012) indicates, while market freedom is a precondition to a free democratic society, the latter may threaten market freedom. Free market should not be subjected to popular vote, it should not be ruled over by any “populist” government (a common swear-word today), and there needs to exist mechanisms to protect that from happening.

Once we have that in mind, it is not so bugging the association that Hayek, Milton Friedman, and the Chicago School once had with authoritarian governments such as Pinochet’s in Chile, one of the most violent dictatorships in Latin American history.

Several liberal economists that occupied important public positions in the Chilean dictatorship had been trained at the Chicago School. The famously known “Chicago Boys” first experimented in Chile what later would be applied in the US and UK and then exported to the rest of the developing world through the Washington Consensus.

In brief, the adoption of some form of authoritarian control over popular sovereignty was deemed acceptable in order to guarantee market sovereignty.

Nevertheless, in the discussions within the early neoliberal groups the boundaries of disciplinary economics were trespassed, and the formulation of neoliberalism – and the Chicago School and MPS – was not grounded on any scientific analytical basis but simply on political affiliation.

The multidisciplinary character, dispersion, and incertitude are some of the reasons why it is hard to give a straightforward definition of what the term “neoliberalism” really means. In order to understand it, we have to mind the set of “dualisms” (capitalism vs. socialism; Keynesianism vs. liberalism; freedom vs. collectivism, and so on) that marked the period. Its defenders (academics, entrepreneurs, journalists, etc.) did not know what their own agenda was – they only knew what they were supposed to oppose. Neoliberalism was born out of a “negative” effort.

It wasn’t until many years later that the division between normative and positive economics came to surface with Friedman and his book Capitalism and Freedom, published in 1962. The increasing participation of economists in the MPS, and a more active public policy advocacy by Milton Friedman brought an end to Hayek’s intention to construct a new multidisciplinary social philosophy.

Economically, Friedman embraced laissez-faire; methodologically, he embraced empirical analysis and positive policy recommendations, getting ever further away from abstract notions of value and moral discussions that his earlier MPS fellows, such as Hayek, were worried about. Neoliberalism lost its path on the way to its triumph; it became a “science” that offered legitimacy to a new credo, a new “illusion”.

As the shadows of neoliberalism became more intertwined with the current neoclassical economics and Friedman’s monetarism, it not only lost its name but also gave birth to a corporate type of laissez-faire; one in which social relations are downgraded to market mechanisms; politics, education, health, employment, it all could fit under the market process in which individuals maximize their own utility. There’s nothing that the government can do that the market cannot do better and more efficiently. Monopolies, if anything, are to be blamed on government actions, while labor unions are disruptive to the economy’s wellbeing. Neoliberalism became a set of policies to be followed: privatization, deregulation, trade liberalization, tax cuts, etc. on a crusade to commoditize every single essential service – or every aspect of life itself.

Hayek believed that these ideas could spread and change the world. And they certainly did. What is worth noting is that there is no fatalistic understanding that neoliberalism was unavoidably a result of historical factors.

The rise of neoliberalism was not spontaneous but rather orchestrated and planned; it was a collective transnational movement to counteract the mainstream of the time; it was originated out of delusion in a period marked by wars, authoritarianism and economic crisis; it was grounded on political affiliations and supported by the dominant ruling class that funded its endeavors and transformed public opinion. These are the roots of what is now the mainstream economic thought.

Brazil Suffers Under a Leader that Believes in Fairies

Brazil’s current economic policy follows the logic of a fairytale. And unless President Temer wakes up to reality, the Brazilian people will continue to suffer the consequences.

In conservative circles, the solution advocated for economic recovery is a reduction in government spending. The argument behind it is that a large government deficit lowers the market’s confidence in its ability to repay. This lower confidence then drives private investment away.

By the same logic, if the government cuts down the deficit, markets are reassured of its commitment to be a good payer. This newly gained confidence drives up private sector investment and the economy grows.

While this may sound like a great way to boost a struggling economy, it’s not. To expect that a reduction in public spending will lead to an increase in private spending in the middle of a recession is like believing in an economic “confidence fairy.” Picture a creature dressed in dollar bills, fluttering eyelashes at private investors while the government takes a step back. With enough fairy dust, investors regain confidence, and the economy turns into a sparkly paradise. It sounds nice, but it’s not real.

The idea of expansionary austerity is a dangerous one. While most of the arguments against government deficit rest upon flawed economic theory, the confidence fairy has its backbone solely on psychological factors that play into private investment decisions. However, what a depressed economy needs is a boost in aggregate demand, many times driven by public investment. Even fairy-enthusiasts, as the IMF, have expressed increasing skepticism towards the ability of austerity to expand an economy.

There are plenty of recent examples that cast doubt on the confidence theory. Take the low growth trap of the world economy, for instance. Several countries struggled with low growth for almost a decade despite their efforts to reduce their budget deficit. As monetary policy played an excessive role, fiscal policy ― and by effect aggregate demand ― was ostracized. New investments do not take place in a depressed economy regardless of the interest rates level or the government debt; in Minsky’s words, investment does not take place as long as the demand price of capital is lower than the supply price of capital.

Nevertheless, Brazil’s Michel Temer continues to be captivated by the fairytale. Amid continuous involvements in the corruption scandals, Temer introduced ambitious austerity measures to cut government spending and reduce the fiscal deficit. Placing his faith in the confidence fairy, he portrays his policies as the only path to recovery and growth ― as if there were a certain magic debt number to achieve.

But thus far, Temer’s policies have failed miserably. Expecting to see the fairy do wonders, 2016’s 3.6% decline in GDP was “unexpected” to Temer’s team. That’s a harsh reality to wake up to, especially since 2015 showed a similar decline in growth. For 2017, the economy is expected to grow 0.5 percent; but growth projections keep getting adjusted downward, and a third year of recession is only half a percentage point away.

Brazil’s collapse in domestic demand is visible in the economy’s capacity utilization. Averaging 73.5 percent in 2016, it’s reached the lowest level since the early 1990s, when the country was plagued by hyperinflation. At this rate, Brazil will have to get through a long period of idle capacity until new private investments can foster demand. Furthermore, the efforts to reduce the government deficit seem to have been futile. The budget deficit has actually surged due to the reduction in tax revenues and the increasing burden of interest rate payments.

Despite everything, Temer isn’t giving up on the confidence fairy yet. Earlier last month, he announced a cut of $42.1 billion reais (approx. US $13.5) in the government budget, nearly a fourth of which on the Growth Acceleration Program for social, urban, and energy infrastructure investment. Other significant cuts were made to the ministries of defense ($5.7 billion reais), transportation ($5.1 billion reais), and education ($4.3 billion reais).

As you may expect, none of this helps to create jobs. On April 28, it became known that the unemployment rate reached a record-high 13.7% for this year’s first quarter. Since the last quarter of 2016, 2 million more people lost their jobs. The number of unemployed now adds to 14.2 million, and that’s more than double the record-low rate of 6.2% in 2013.

Unlike the President, the people of Brazil know they can’t count on fairy dust. Last week, workers went on a general strike, during which millions of Brazilians protested against the austerity agenda. As much as 72 percent of the population opposes the reforms that are being discussed today, and government approval rates are as low as 10%.

But Temer ignores all cries of concern and keeps going steady. Two of his the structural reforms have already been initiated. Real government spending is frozen for the next 20 years, and labor market is under flexibilization. A third, more complex one is the pension reform, whose main proposal is to increase the minimum retirement age and time of contribution. Although the subject is too extensive to be covered in here, it’s worth mentioning that the pension reform disregards some of the social inequalities in the country (e.g. conditions of rural and poor workers) and it solely focus on curbing the long-term system’s expenditure instead of dealing with the falling revenues that collapsed in recent years due to tax breaks and the crisis.

Together, these reforms dismantle any efforts at building a social welfare system in Brazil. Crucial areas for public investment such as education and health will suffer.

Right now, it’s more clear than ever that Brazil’s story is not a fairytale, but a living nightmare. And there’s no confidence fairy that can fix it. As Skidelsky puts it, “confidence cannot cause a bad policy to have good results, and a lack of it cannot cause a good policy to have bad results, any more than jumping out of a window in the mistaken belief that humans can fly can offset the effect of gravity.”

Using Minsky to Better Understand Economic Development – Part 2

The work of Hyman Minsky highlighted the essential role of finance in the capital development of an economy. The greater a nation’s reliance on debt relative to internal funds, the more “fragile” the economy becomes. The first part of this post used these insights to uncover the weaknesses of today’s global economy. This part will discuss an alternative international structure that could address these issues.

Minsky defines our current economic system as “money manager capitalism,” a structure composed of huge pools of highly leveraged private debt. He explains that this system originated in the US following the end of Bretton Woods, and has since been expanded with the help of financial innovations and a series of economic and institutional reforms. Observing how this system gave rise to fragile economies, Minsky looked to the work of John Maynard Keynes as a start point for an alternative.

In the original discussions of the post-war Bretton Woods, Keynes proposed the creation of a stable financial system in which credits and debits between countries would clear off through an international clearing union (see Keynes’s collected writings, 1980).

This idea can be put in reasonably simple terms: countries would hold accounts in an International Clearing Union (ICU) that works like a “bank.” These accounts are denominated in a notional unit of account to which nation’s own currencies have a previously agreed to an exchange rate. The notional unit of account – Keynes called it the bancor – then serves to clear the trade imbalances between member countries. Nations would have a yearly adjusted quota of credits and debts that could be accumulated based on previous results of their trade balance. If this quota is surpassed, an “incentive” – e.g. taxes or interest charges – is applied. If the imbalances are more than a defined amount of the quota, further adjustments might be required, such as exchange, fiscal, and monetary policies.

The most interesting feature of this plan is the symmetric adjustment to both debtors and creditors. Instead of having the burden being placed only on the weakest party, surplus countries would also have to adapt their economies to meet the balance requirement. That means they would have to increase the monetary and fiscal stimulus to their domestic economies in order to raise the demand for foreign goods. Unlike a pro-cyclical contractionist policy forced onto debtor countries, the ICU system would act counter-cyclically by stimulating demand.

Because the bancor cannot be exchanged or accumulated, it would operate without a freely convertible international standard (which today is the dollar). This way, the system’s deflationary bias would be mitigated. Developing countries would no longer accumulate foreign reserves to counter potential balance-of-payment crises. Capital flows would also be controlled since no speculation or flow to finance excessive deficits would be required. Current accounts would be balanced by increasing trade rather than capital flows. Moreover, the ICU would be able to act as an international lender of last resort, providing liquidity in times of stress by crediting countries’ accounts.

Such a system would support international trade and domestic demand, countercyclical policies, and financial stability. It would pave the way not only for development in emerging economies (who would completely free their domestic policies from the boom-bust cycle of capital flows) but also for job creation in the developed world. Instead of curbing fiscal expansion and foreign trade, it would stimulate them – as it is much needed to take the world economy off the current low growth trap.

It should be noted that a balanced current account is not well suited for two common development strategies. The first is import substitution industrialization, which involves running a current account deficit. The second is export-led development, which involves a current account surplus. However, the ICU removes much of the need for such approaches to development. Since all payments would be expressed in the nation’s own currency, every country, regardless it’s size or economic power, would have the necessary policy space to fully mobilize its domestic resources while sustaining its hedge profile and monetary sovereignty.

Minsky showed that capable international institutions are crucial to creating the conditions for capital development. Thus far, our international institutions have failed in this respect, and we are due for a reform.

Undeniably, some measures towards a structural change have already been taken in the past decade. The IMF, for example, now has less power over emerging economies than before. But this is not sufficient, and it is up to the emerging economies to push for more. Unfortunately, the ICU system requires an international cooperation of a level that will be hard to accomplish. Aiming for a second-best solution is tempting. But let’s keep in mind that Brexit and Trump were improbable too. So why not consider that the next unlikely thing could be a positive one?

Using Minsky to Better Understand Economic Development – Part 1

The global system has seen two major shocks in 2016: the Brexit vote and Trump. What these events have in common is their populist rhetoric that promised to bring back jobs. These elections have tapped into growing anxiety over job security, which has not been addressed by most governments and has given room for demagogues to tap into the anger of the people. They reflect a problem that transcends the boundaries of any single nation: the global economy has been in a slump for almost a decade. Governments need to create jobs, and public fiscal stimulus is the way to do so. To allow it, we must rethink that system.

To understand why we have to consider the international system in which nation states currently operate in. Its current characteristics present challenges for developed and developing economies alike. There are two important features to consider: first, the system creates a deflationary bias by requiring recessionary adjustments and hoarding of the international mean of payment (i.e. dollars). Second, it lacks mechanisms to offset the chronic surpluses and deficits between nations, thus breeding financial instability. In a nutshell, it leads to poor creation and distribution of demand that is managed through capital flows. Instead of propping up demand, the global economic system props up debt.

This post will be split into two parts. This first part will employ the theories of Hyman Minsky to explain the features of our current global economy. Next week, we will follow up to discuss an alternative system that would allow for a better distribution of demand among countries and would support emerging economies’ development by freeing them from the swings of international markets.

In his Financial Instability Hypothesis, Minsky addresses the ability of a company to honor its debt commitments. Companies can finance investment through previously retained earnings (internal funds) and/or by borrowing (external funds). If retained earnings prove to be insufficient, and the company comes more and more reliant on borrowed funds, the company’s balance sheet structure shifts from being stable to unstable. As presented in a previous post on this blog, Minsky described this process as moving from a stable “hedge” profile to a riskier “speculative” profile, and finally to a dangerous “Ponzi” profile.

Similarly, a country has three ways in which it can meet its debt commitments denominated in foreign currency: i) by obtaining foreign exchange through current account surpluses; ii) by using the stock of international reserves (obtained through previous current account surpluses); and iii) by obtaining access to foreign savings, i.e. borrowing. The first characterizes a hedge financial profile in which the cash inflows are sufficient to pay the foreign currency denominated liabilities. Any mismatch between inflows and outflows can be covered by reserves (its cushion of safety) or by borrowing; while the former can still characterize a hedge profile – as long as the cushion of safety is big enough to cover the shortfall for the necessary period of time – the latter is said to be speculative. In other words, the country borrows to cover a mismatch with the expectation that future revenues will be used to meet those debt obligations.

A situation in which further rounds of borrowing are necessary to meet those commitments is by definition a Ponzi scheme. It can only be sustained over time if it manages to keep fooling investors to continue to lend. Once a greater fool is not found and financial flows are reversed, the economy collapses in a Fisher-type debt deflation: as assets are liquidated to meet those financial obligations, their prices fall and the debt burden becomes increasingly heavier. The case of a country is different from a company, where outflows are often accurately expected, and it commonly leads to massive capital flight, currency devaluation, fall in public bond prices and increase in its premiums (i.e. interest rate payments). This last point illustrates the implications of accumulating foreign liabilities – reserves included – and implies the growth of negative net financial flows from borrowers to creditors through debt servicing. In general, from developing to developed countries.

The adjustment process punishes the borrower much harder than the lender. Greece presents a clear example. For the borrowing country, the standard imposed remedy is austerity: curtail of imports and public expenditure in order to forcefully meet those debts. Or, more often, to stir up enough confidence and access additional financial resources from private investors; in other words, continuing the Ponzi financing. Even in a case where interest payments on the borrowed funds are lower than the rate of capital inflow, the stock of debt would still expand, increasing financial fragility. A development strategy dependable on increasing usage of foreign savings is thus not feasible.

Of course, economic development is an extremely broad subject and we sure don’t want to commit the mistake of suggesting a “one-size-fits-it-all” policy a la neoliberal disciples. Nonetheless, a common issue for many developing economies is the lack of complexity and variety of its production structure – heavily dependent on primary goods – and the low price-elasticity of demand for its exports, which means that shifts in prices (exchange rate) do not do much to stimulate exports (increasing demand). As such, price adjustments might not always work as expected. This is one of the rationales behind the familiar “import substitution industrialization” strategy that tragically seems to have become the case for the UK and US.

These common characteristics affect the ability of emerging economies to face both up- and downswings of the international economy with countercyclical policies. While international liquidity is abundant in booming periods, it becomes extremely scarce during the slumps. Both capital floods and flights can be domestically disruptive for a developing economy, affecting its employment and output level, solvency, and – ultimately, its sovereign power. With scarce demand and international liquidity, the indebted economy falls into the debt-deflation spiral: it has to incur in a recession big enough to collapse imports at a faster rate than exports thus generating surpluses to clear off debt.

It should be clear that besides being completely inefficient – as opposed to the argument commonly used by “free-the-capital” defenders – the current economic system does little to stimulate demand. It is quite the contrary. Notwithstanding, after almost 10 years after the financial crisis, the world economy is still suffering the consequences of economic “freedom,” and the fighting tool has focused excessively on monetary rather than fiscal policy. Instead of cooperation, we are prone to have currency wars, protectionism, “beggar-thy-neighbor” policies and chronic debt accumulation.

These points of criticism are not novel, but they do deserve more of our attention. The same applies to their solutions, which are the focus of Part 2 of this article.

The Brazilian Burden

On August 29th Dilma Rousseff, the democratically elected Brazilian ex-president, defended herself at the Senate against accusations of fiscal fraud, the so called “pedaladas fiscais.” Despite her defense, two days later, the president was formally impeached, putting an end to a process that has been carried on since May, when she first left office to face trial. The crime accusations were mainly accompanied by harsh criticisms of how the Workers’ Party (Partido dos Trabalhadores, PT) fiscal irresponsibility led to the poor economic condition that the country finds itself. Among the economic meltdown and several scandals of corruption, her approval rate and the popularity of her party collapsed in recent years. After 13 years of the leftist PT administration, the presidency is now occupied by the then vice-president Michel Temer, member of the centrist Brazilian Democratic Movement Party (Partido do Movimento Democrático Brasileiro, PMDB), a party also involved in corruption scandals, and whose popularity is as bad as his predecessor.

Political matters “apart,” the Brazilian economic situation is indeed dire. GDP is expected to contract 3.18% in 2016, a second year of contraction, following the 3.85% in 2015. Unemployment increased more than four percentage points from the beginning of last year, reaching 11.3% in June 2016. Despite the poor economic performance, inflation is still above the 6.5% target roof, being expected to accumulate 7.4% this year. The inflationary pressure comes mainly as an effect of the rapid exchange rate nominal devaluation of almost 54% within the years of 2015 and 2016, reaching now R$ 3.29 per dollar. As an attempt to control inflation and attract foreign capital, the Brazilian Central Bank – going in the opposite direction of the major Central Banks – sharply rose the short-term interest rate (Selic), sustaining it at 14.25% (!!!) since mid-2015. This also had a feedback effect on the government’s total deficit. (*)

Two questions remain open: what are the real roots of the economic crisis and will the new administration be able to tackle it? To understand the roots of the bust, it might be easier to refer to the very causes of the boom that preceded it.

The boom and bust

From 2002 to 2008, the Brazilian economy performed really well, growing at an average of 4% per year. This was possible mainly by a combination of policies aimed to reduce poverty and income inequality along with the positive international scenario.

Increasing worker’s real wages and government cash transfers to poor households – channeled mainly through social security and the famous Bolsa Família – established a virtuous cycle of increasing private consumption. Another important factor was the promotion of policies towards labor-market formalization, which guaranteed not only access to social security but also the availability of poor households to private lines of credit. Note, however, that not only poor households benefited from “cash transfers”: the historically high short-term interest rate guaranteed that rich households too enjoyed the fruits of the boom. The government managed to attend then both extremes of the income distribution.

International conditions also played a major role in boosting the domestic economy. High international liquidity and the commodity-price super cycle guaranteed appreciation of the exchange rate, which beyond positively impacting domestic real wages, also helped to keep inflationary pressures under control by making foreign goods more accessible.

The Brazilian economy suffered its first hit with the 2008 financial crisis. Despite the GDP growth of 7.5% already in 2010, the fast economic recovery was mainly a result of aggressive counter-cyclical expansionary policies by the government, who acted through state-controlled enterprises (as the oil and energy companies, Petrobras and Eletrobras) and programs of investment in economic and social infrastructure. From 2011 on, GDP returned to low levels, making it necessary for the government to adopt a new set of policies that can be summarized in tax exemptions and subsidized credit expansion to private companies from public banks. As it happens, this attempt to increase private investment had the only effect of deteriorating the public fiscal situation.

The budget, the budget!!!

The change in orientation of government policies – from an expansion of public investment in 2008-10 to a provision of fiscal stimulus to private companies in 2012-14 – happened at the same time as the commodity boom ended. Already in 2011, commodity prices stagnated and, along with Brazilian terms of trade, started its downward path in 2014. The end of the commodity cycle had a harsh impact not only in economy’s aggregate demand but also on the fiscal budget.

Before we get to the fiscal issue though, please, don’t get me wrong. The cause of the Brazilian economic crisis is less a result of the end of the commodity boom in itself than by the productive structure that such cycle reinforced. Brazil’s external sector is highly dependent on the exports of primary goods, and this dependence only deepened in the past decade. In 2015, roughly 50% of Brazilian total exports were composed by primary products, a number that increased 4.5% per year since 2002, when it accounted for less than 30%. If we include natural resource-based manufactures on the calculus, it reaches nearly 70% of total exports! Furthermore, while labor productivity increased 5.3% per year from 2000 to 2013 in the agriculture sector, it decreased 0.6% per year in the manufacturing industry.

No wonder when commodity prices reverted trend the economy took a strong hit. Instead of setting the ground for the eventual bust, Brazil placed all its coins on booming commodities. Despite all the public investment programs and fiscal exonerations to the private sector, the PT administration did not manage to increase investment as share of GDP, which remained stagnant around the 18% level throughout 2002-2015 – with public investment accounting for less than 3% of GDP. Lack of investment in infrastructure and manufacturing industry perpetuated an anemic economy with low productivity and dependent on economic cycles.

Public consumption and investment decreased even further after 2014 when the rapid deterioration of the fiscal budget turned the 3%-of-GDP government fiscal surpluses to almost 3%-of-GDP deficits. It is interesting to notice that the decreasing surpluses started in 2011, not accidentally when commodity prices stagnated. We can look at the three institutional balances for the Brazilian economy, representing the government, private, and foreign sectors, as follows below in order to see these trends more clearly.

We already know from previous posts on this blog (see here and here) that the government sector has a “crowding-in” effect on the private sector, meaning that government expenditure will, by an account identity, revert in private sector savings. Of course, in an open economy, this is only true as long as we assume the foreign sector to remain “stable”. Both the private and government sectors can only simultaneously run a surplus if the foreign sector generates a surplus that is big enough to account for both. (The intention of the figure presented is not to show that the balances sum to zero – which could be demonstrated by inverting the sign of the private sector and using a bar graph – but to show the movements of the financial assets and liabilities between the three sectors).

In the case of the Brazilian economy, the improvement of the foreign sector in 2001 allowed an increase in the private sector savings and a decrease in government total deficits. Once the financial crisis struck at the end of 2007, despite the counter-cyclical policies, the deterioration of the current account was mainly absorbed by a decrease in savings of the private sector, with government persisting to run primary surpluses and to sustain its total deficit level – even decreasing it until late 2012. On that year, we observe a sharp deleveraging of the private sector which, given the steady trend of the current account, was completely mirrored by the public sector.

Once again, the mistake – to name one – of the PT administration is that instead of increasing fiscal stimulus through direct government expenditure and investment in infrastructure it bet on providing credit and fiscal exonerations to the private sector as an attempt to increase private investment. In a scenario in which – to use Minsky’s terminology – the demand price of capital decreases at a faster rate than the supply price of capital, investment will not take place. In other words, despite the stimuli reducing the cost of new investment, expectations of profits were falling at a faster rate. In a situation of lack of aggregate demand, the government has to directly spend in order to create the necessary stimulus to the private sector through the generation of profits. Its avoidance led to the deterioration of the fiscal budget through the revenue side, surpassing now 10% of GDP, a result of the economic meltdown.

Instead of stimulating the economic activity by driving aggregate demand and adjusting the economy by sustaining the levels of output and employment, the government opted, mainly after 2014, for a “building confidence” strategy in which it compromises to reducing inflation, generating primary surpluses by increasing interest rates, and cutting government deficits, an adjustment that comes, in such case, through deepening the economic recession. All of it with the intention to attract market’s attention and foreign capital inflows. It, in fact, has a huge potential to generate financial fragility – but this is subject for another post.

And what now?

To address the second question posed at the beginning of this text, it is hard to believe that the new administration will be able to revert the dire scenario. It is still unsure if Temer will have the political leverage to pass important fiscal structural reforms in Congress, such as pension reform. Temer’s pledge to sharply reduce the government deficit can be summarized in the attempt to pass a law that will impose a limit to government expenditure indexed to the inflation level of the previous year. Besides reducing the ability of the government to invest, it also means cutting spending on areas such as education and public health, thus reducing the welfare state that was established in the previous decade, a major element in the virtuous cycle.

Whether or not promising to reduce inflation and the public deficit will be miraculously enough to stimulate agents confidence in the future, it will for sure hurt the economy and lead to a further decrease in demand price of investment in the short-run. In a situation of deleveraging private sector and slow global trade, it is unlikely that private investment will rise anytime soon. Until then, workers will be the ones to suffer from the increasing unemployment levels. The interest rate, beyond undermining any conceivable investment effort that could come from private agents, also carries a feedback effect to government budget and a distributive matter, as mentioned in the beginning of this text. When the pressure to cut government spending increases, “attend both extremes of the income distribution” becomes a hard job. We already know which side was chosen. Unfortunately, very often the adjustment burden comes from the weaker side.

(*) All the data presented in the text are extracted from the Brazilian Central Bank (BCB) and the Brazilian Institute of Geography and Statistics (IBGE).

A Sinking Ship

Eight years ago, the world economy was shaken by the worst financial crisis since the depression of 1929. Despite the trillions of dollars spent on bailouts and on governments’ attempts to stimulate the economy through monetary policies, the world has not yet fully recovered, and several developing countries are facing their bitterest share just now. Still, many refrain from acknowledging the necessity of governments to engage in a different – and more effective – policy to boost economic activity and employment: fiscal expansions. Nevertheless, the burden is getting so heavy that even the more skeptical are turning to reason.

A recent text written by three important economists at the IMF, titled Neoliberalism: Oversold? has drawn a lot of attention in the past days. Perhaps the most impressive matter that should be highlighted about the text is in its very title: the use of the word neoliberalism, so far mostly used by critics of this agenda that gained strength in the 1980s and generally associated with a sort of “conspiracy theory”. Besides that, the findings of the text should come as no big surprise to non-mainstream economists: instead of economic growth, neoliberalism has brought financial instability and increasing inequality.

This is due to two main pillars of the neoliberal agenda: capital flows liberalization and government fiscal consolidation. Freedom of the capital accounts was expected to bring about a more efficient allocation of resources at an international level. Both developed and developing countries would reap benefits from it: the former by obtaining higher returns on capital investment and the latter by receiving the necessary savings to finance capital development.

The same is true for austerity policies, which would lead to a more efficient allocation of resources domestically. Two main ideas associated with fiscal consolidation are the famous “crowding-out effect,” in which government expenditure would decrease the availability of resources to the private sector thus not resulting in any real change in the economy (a mechanism adjusted by the interest rate), and the “burden of debt”, in which public indebtedness would necessarily lead to higher taxes in the future, then transferring the “burden” to pay off the debt to the future generations.

By looking into data, the IMF authors reach the conclusion that the beneficial effects of such policies “appear to have been somewhat overplayed”. Indeed, instead of stimulating economic growth, those policies have resulted in decreasing output. Capital account liberalization has been much associated with financial instability (especially in the recipient countries), and fiscal cuts with increasing unemployment. Most importantly, such policies seem to lead to increasing economic inequality, which hurts the sustainability of economic growth in the long-run.

Fiscal consolidation and free capital flows have led to the trap that the world economy is now found: a sinking ship commonly referred to as “secular stagnation”. After almost a decade has passed since the financial crisis and advanced economies still have not engaged in fiscal stimulus despite the failure of the non-orthodox monetary policies on bringing about robust growth. Instead of having that money spent into the economy, banks and other private investors were just sitting on it – apparently, not even negative interest rates managed to encourage lenders, showing the limits of monetary policy to generate growth and sustain employment.

Furthermore, in a world in which capital flows are free, high international liquidity was mostly drained by developing economies due to the high-interest rate differentials. The increase in capital flows has a direct impact both on foreign reserve accumulation and exchange rates, which can have disruptive effects for developing countries hurting foreign trade competitiveness and risking a balance of payment crisis. In a case of increasing country’s indebtedness denominated in foreign currency, a change in the perception of international lenders might lead to either capital flood or capital flight.

This deserves special attention in the current state of the world economy. The US has not yet reached the levels of inflation that it aims (despite the plan to continue the interest rate hikes), China is going through a downturn and a restructuring of its economy towards a consumer-based one, Europe is in the brink of dismantling, and Latin America is struggling both politically and economically (with Brazil as one of the protagonists). The drop in global trade and the reverse in money flows can bring about an obstacle to the ability of developing countries to obtain foreign exchange, and thus to meet their foreign debt commitments.

With decreasing global demand and a lack of willingness to make use of fiscal stimuli, the burden of the adjustment during this sluggish riptide is the employment level. In a report from January, the International Labour Organization (ILO) estimated that world unemployment is likely to reach 200.5 million in 2017, an increase of 3.4 million new jobless people within this and the next year, with the developing and emerging economies in Latin America, Asia and Africa taking the worst impact, plummeting along with commodity prices.

How can we stop the ship from sinking? A coherent global effort to generate demand and employment is needed. Governments, especially in countries with greater economic and political leverage (such as US and Germany), should engage in fiscal expansions targeting investment and employment. With investors’ animal spirits leashed, policymakers should not count on the private sector as a source of aggregate demand, and neither on exporting their way out of the crisis – as in a “beggar-thy-neighbor” type of policy. Instead, direct employment creation should be an objective of a global coordination, which then would provide the necessary aggregate demand to revive global trade, besides being a great mechanism to tackle the neoliberal trend of rising inequality.

Ideally, this should be the first step towards a more substantial change in the international financial architecture: from one that incites financial instability through chronic current account deficits/surpluses and abrupt movements of capital, towards one that nurtures and sustains stability and employment in the long-run. [For an enlightening discussion on the subject, see here].

What we shall remember is that although developing countries are being the first ones to fall into the cold waters of depression, the whole ship will sink eventually unless the proper policies are adopted – and austerity and liberalization have proven not to be useful lifebuoys.

Written by Vitor Mello
Illustration by Heske van Doornen