Brazil's Hard Road to Affluence

Too good to be true? In a word: yes. But there's still much to be learned from this latest ride on Brazil's development roller coaster. In particular, that true institutional change comes slowly. And without change that more clearly limits the role of government and focuses on getting economic incentives right, the economic pie won't grow sufficiently to sustain a just and prosperous society.

Looking back, it's easy to see why longtime Brazil watchers allowed themselves to hope this time would be different. During his two-term administration (2003-10), Lula scored some stunning successes. GDP growth averaged 4.1 percent – tepid, perhaps, by East Asian metrics, but heavy duty by Latin American standards. Some eight million jobs were created. More impressively, Lula managed the process of growth without exacerbating the country's notoriously awful inequality. Quite the contrary: the income of the poorest half of households grew at nearly twice the rate of the top 10 percent; all told, 17 million Brazilians climbed out of poverty.

Meanwhile, inflation was held to 6 to 7 percent, down from around 15 percent in the 1980s and '90s. Even in the midst of the 2008-9 global financial crisis, Brazil continued to defy claims that inclusive growth was impossible in a Latin American context.

Indeed, by 2010, Brazil appeared to be on the cusp of becoming a major contender on the emerging-market fast track. Brazilian-style growth-with-a-heart was hailed as a viable democratic alternative to the Chinese authoritarian model or the privatize-or-perish free market approach forced on developing countries by international lenders. Believers saw Brazil's third way as a model for other Latin American countries, and maybe eventually for sub-Saharan Africa.

Then, as suddenly as the good times arrived, they vanished. Under Lula's hand-picked successor, Dilma Rousseff, the economy fell into deep recession. What had started out as a virtuous circle of broad-based growth under Lula rapidly turned into a vicious circle of economic contraction, ballooning debt, soaring interest rates and a sharply falling exchange rate under Rousseff. In 2013, mass protests swept Brazil for the first time in decades. In May of this year, Rousseff was suspended by the legislature: In August, she was removed from office.

With 20-20 hindsight, it's easy to explain what happened. All it took was a poisonous mix of rapidly falling commodity prices as the global economy stumbled (Brazil exports a lot of oil, iron ore and soybeans) and serious mismanagement of fiscal policy as government revenues shrank. The country's pervasive corruption became harder to ignore as the economic pie shrank. But the speed and depth of the downturn left a lot of observers wondering whether Brazil's third way wasn't to blame. Which leads to a big question: can Brazil's no-family-left-behind growth model be salvaged – not just in Brazil, but throughout Latin America?

Lula and the Brasilia Consensus

As in many Latin American countries, Brazil's approach to economic development before Lula was largely driven by the conviction that industrialization was Priority One. That required tariff and quota protection against cheaper, better-made imported manufactures. Although this approach worked (well, sort of worked) in the 1960s and '70s, the chickens came home to roost in the 1980s. Low productivity and dysfunctional markets, compounded by macroeconomic policies that left the economy exceptionally vulnerable to runaway inflation, constrained development.

Despite Brazil's vast natural resources and rapidly growing labor force, GDP growth averaged only 3 percent in the 1980s and 1.9 percent in the 1990s. From 1960 to 2000, labor productivity growth averaged 1.7 percent, compared with 6.6 percent in South Korea and 7.8 percent in China. The country's teeming, violence-ridden favelas became symbols of the Brazilian elite's indifference to extreme poverty. Income inequality was the highest in the Americas and gave a lot of failed African states a run for their greed.

The year 2002 saw the election of Workers' Party candidate Lula da Silva, a tough, leftist union leader who had fought the military governments of the 1980s. He surprised just about everybody by maintaining the prudent macro policies of his center-right predecessor, Fernando Henrique Cardoso, who had conquered quadruple-digit inflation. And, as discussed, Lula expanded programs targeted at relieving poverty with minimal impact on market efficiency.

Specifically, Lula expanded the "conditional cash transfer" social programs first introduced by the Cardoso administration. Low-income families received monthly cash stipends in return for commitments to send their children to school and to remain up to date on vaccinations. In 2006, roughly one in four Brazilian households were covered, virtually eliminating extreme poverty at modest cost – an annual outlay of just 0.5 percent of GDP. Instead of pursuing a classic outward-oriented development policy, the export-led growth approach that has worked so well in East Asia, Lula made lemonade from lemons. He accepted Brazil's relatively low savings rate as a given, harnessing increased personal spending to fuel the growth of jobs and wages.

Lula's Brasilia Consensus also deviated radically from a conventional free-market approach by intervening in key markets to give domestic firms a leg up on foreign competitors. This was uncomfortably similar to Brazil's failed import-substitution strategy of the 1960s and '70s; the government imposed high tariffs on many imported goods to provide a protected market for Brazilian firms and to encourage foreign manufacturers to set up production facilities in Brazil. To promote industrialization, the government subsidized credit through the state-run development bank. For foreign direct investors, state involvement was somewhat heavier-handed – for example, imposing local-content rules and local sourcing requirements on foreign firms in the mining and oil/gas sectors.

The four main elements of the third-way Brasilia Consensus proved roughly complementary. Macroeconomic stability helped preserve the purchasing power of household income, which was supplemented by the country's social programs. Increased family income spurred domestic demand to drive the growth of jobs and wages. At the same time, industrial policies favoring domestic production helped maintain employment and create incentives for foreign direct investment.

Interestingly, research suggests that Brazil's cash-transfer programs accounted for only one-fifth of the reduction in income inequality. Economic growth and the associated expansion in employment, plus minimum wage increases and subsidized credit to small businesses through the public banking system, accounted for the rest. 

From a political perspective, the Consensus worked (or at least endured) because Lula managed to redistribute income without directly confronting Brazil's business elite. In fact, he sought a convergence of interests between labor and business though the expansion of private consumption. Rates of investment were never high by emerging-market standards. But they were high enough to sustain a reasonable rate of growth. By the same token, government spending as a portion of GDP was high for an emerging-market economy. But steady growth made it possible to keep budget deficits low and inflation in check.

Virtuous to Vicious Circles

I know what you're thinking: did Lula do it all by magic? Protectionism and promotion of growth through the expansion of consumption are widely viewed by mainstream economists as a problematic route to prosperity – at best, a temporary fix for an economy that is operating below capacity and only needs the expansion of demand (any sort of demand) to make everybody better off.

Actually, Lula benefited more from luck than magic – the global commodity boom carried Brazil a long way. Lula's successor could not sustain prosperity based solely on rising demand. What started out as a virtuous circle of mutually complementary policies that expanded economic activity, reduced poverty, blurred ideological divisions and made it possible to run a stable macro policy without encountering bitter political resistance turned into a vicious circle of contraction and instability under Lula's successor.

After Rousseff took office in 2011, Brazil's growth slowed sharply; then, in 2014, the economy went into recession and shrank 3.9 percent. The IMF predicts further shrinkage (more than 3 percent) this year. Unemployment, which decreased from 11.7 percent to 6.8 percent under Lula, drifted back up to 9.2 percent this year; squeezed between falling tax revenues and rising welfare obligations, the budget deficit has soared.

The current slowdown is not unique to Brazil. As a major commodity exporter, Brazil, like fellow emerging-market stars, Russia and South Africa, faces lower prices and volumes. However, many other commodity exporters were better prepared to weather the downturn. In fact, when Chile experienced a major currency depreciation in the wake of falling commodity prices, its government used the weakness to improve the country's competitiveness in other areas. As a result, Chile has been able to maintain 2 percent-plus growth.

But Rousseff's version of Lula's third way only dug Brazil into a deeper hole. Instead of using the emergency to introduce measures that would increase market efficiency, she doubled down on state intervention, papering over low productivity with credit subsidies. Incipient inflation was tamped down with price controls in key sectors. And with no growth to show for the effort in private markets, her government resorted to infrastructure spending: government outlays as a percentage of GDP under Rousseff have averaged 37 percent, compared with 33 percent under Lula. Yet Brazil has little to show for the expenditure, in part because a lot of the money has been dissipated by corruption.

The current macro statistics paint a grim picture. Export revenues are down sharply – the current account deficit was 4.3 percent of GDP in 2015, leading to a 30 percent-plus depreciation of Brazil's currency, the real. Inflation is approaching double digits and wages aren't keeping up, adding to popular frustration.

Meanwhile, the budget deficit, which had been in check for so long, climbed to 10.5 percent in 2015. But deep into a recession, Brazil is hardly in a position to cut social welfare payments that are more important than ever to the nation's poor and near-poor. Rousseff disguised the deteriorating fiscal situation during her 2014 re-election campaign; later, that fiscal sleight of hand was used as the legal wedge to drive her from office.

The country's lack of progress in basic governance and economic reforms is, of course, only reinforcing the vicious cycle. Brazil's percentile ranking for government effectiveness on the World Bank's Worldwide Governance Indicators fell from an average of 55 under the right-center regime of Cardoso to 53 under Lula to 50 under Rousseff. The country's percentile ranking on corruption eroded from an average of 59 under Cardoso, to 56 under Lula and 55 under Rousseff. The percentile ranking for regulatory quality also declined, from 64 during the Cardoso administration, to 56 under Lula and 54 under Rousseff. By comparison, Chile has consistently ranked in the 85th percentile for government effectiveness and control of corruption and above the 90th percentile for regulatory quality since the World Bank first introduced the governance indices in 1996.

Progress in governance is critical if Brazil is not only to make the economy more resilient to global shocks, but also to lay the foundation for the next stage of development. Brazil is in the latter stages of what economists call a "middle-income trap" in which growth potential slows sharply after it runs out of easy sources of gains like movement from low-productivity agriculture to high-productivity manufacturing and services.

To break out, it is critical to begin the transition from growth based on the accumulation of capital and labor and the exploitation of natural resources to a knowledge-based economy in which innovation makes capital and labor more productive. Countries that don't get better at governance – credible corruption fighting, rule of law, regulation with a lighter touch – as they progress through stages of development can't expect to make the leap to the prosperity possible in sophisticated, service-driven economies.

Brazil has also regressed on the Heritage-Wall Street Journal Index of Economic Freedom. While there have been limited attempts at market-oriented reforms, state controls remain especially burdensome in key areas ranging from electricity to financial services. Brazil currently ranks 122nd of 178 countries, well below decidedly un-free economies like Nicaragua, Saudi Arabia and Egypt. As the index's subcomponents show, large drops under Lula in Brazil's business and fiscal freedom have been sustained under Rousseff. Meanwhile, trade freedom, which increased under Lula, leveled off under Rousseff.

Other statistical ranking systems cast Brazil in the same weak light. When Lula left office, Brazil ranked 48th out of 144 countries on the World Economic Forum's Global Competitiveness Index. In 2015-16, the country ranked 75th out of 140 countries. The rankings are especially low in institutional quality (121), macroeconomic environment (117), health and primary education (103), goods market efficiency (128), labor market efficiency (122) and innovation (84) – hardly the profile of an economy eager for comparisons with Western Europe, North America or the high-income economies of East Asia.

Indeed, looking back, the early success of Brazil's third way seems mostly the product of a serendipitous mix of the global commodity boom, the demand-driven closing of a chronic gap between actual and potential GDP, and the easy pickings to be had from adopting straightforward income support for the poor. When more was required to sustain growth, Brazil came up short.

Hard Lessons

The appeal of third-way approaches to development is obvious. Pretty much every great development success has taken a high human toll. Lula promised development without tears, and he pulled it off – for a while. But he never tackled the gnawing problem of corruption, and he relied on subsidies to paper over low productivity. Before the current economic crisis, Brazilians tolerated corruption because, as the popular saying goes, "Rouba, mas faz" – he robs, but he gets things done. With nothing much getting done in recent years, tolerance is at an end.

That said, Lula's efforts to attack poverty by means other than trickle-down were admirable. And there is no good reason that more conventional (and more likely to succeed) approaches to development couldn't be complemented with carefully targeted efforts to relieve the misery. Indeed, the conditional cash transfer system pioneered in Brazil has been widely imitated – and has generally proved effective – in Latin America.

Brazil is a land of immense economic promise and immense disappointment. It is also becoming an icon of the reality that shortcuts to development are deeply problematic. The big question is when (and whether) Brazil will be able to lay the cultural and institutional foundation to build a stable, prosperous society.