Improving Krugman – A Story About Brazil

Paul Krugman tells a story about the Brazilian economic crisis of 2015-2016. I am usually a fan of his large economic brain. You can disagree with his politics, and even quibble with his economics, but any objective reading of the outturn since the GFC makes it clear that he got the big things right when very few others did.

His story about Brazil, however, while not outright wrong, could be substantially improved. He argues that the trifecta of a commodity shock, large domestic debt burden, and application of expansionary austerity (contractionary fiscal and monetary policies) did them in.

First, Brazil is not a big commodity exporter as a share of GDP. The pervasiveness and persistence of this misconception goaded me into posting this a few years back.

The TL;DR is that Brazil’s exports are not only about 11 percent of GDP (very low by EM standards), but the ratio actually declined over the course of the boom years (from 15% of GDP to 11%). Hardly what you’d expect to see in an export-led boom—even if you account for currency appreciation on the export share of GDP.

This doesn’t mean that the terms-of-trade shock didn’t matter. It certainly had a negative effect on output, especially when you consider the negative signaling effect to foreign investors who deeply bought into that narrative, and had, by that point, already become a material part of Brazil’s domestic debt financing. But at 11% of GDP, this part of the story was not nearly as nasty as it was made out to be.

Second, he lays a lot of blame at the feet of the Brazilian policy response. And in a very strict sense, he’s right. Raising rates in an economy that just built up a lot of domestic debt (more on that in a sec) while contracting the fiscal position will hit an economy like Brazil’s hard. Government outlays there are a large share of GDP (IIRC just under 40%).

The important omission here though is “how risky would simulative policies have been”? In most developed economies—and certainly in the US–policy credibility allows for expansionary fiscal and accommodative monetary when there’s a downturn. This is not the case in emerging market countries. In fact, many would argue that this is the defining distinction between EM and DM countries.

To the point, the legacy of liquidity and solvency crises in emerging markets results in running the risk that expansionary countercyclical policies scare investors—rightly or wrongly—and induce more aggressive retrenchment by foreign portfolio investors and further capital flight by locals. The muscle memory in Latina America on this runs particularly deep.

As a rule of thumb, the greater the perception that a country is or could easily be faced with a liquidity-cum-solvency crisis, the greater the risk that expansionary countercyclical policies prove counterproductively tragic. At some point along the credibility spectrum countries decide, understandably, that it’s not a policy risk worth running.

The real culprit in the Brazilian crisis was the sudden stop. Not the classic sudden stop à la Calvo, but the sudden stop of domestic credit. And this is the part where Krugman gets the emphasis right, citing Atif Mian et al.

From 2003 to 2014, domestic credit to the private sector in Brazil went from 23% of GDP to 70%. This, not exports, is what fueled the economic boom (and in many other EM countries in the same period). It left Brazil with a credit overhang it had to digest and a lot of debt that needed to be rolled over at higher rates, as Brazil jacked up the SELIC (Brazil’s policy rate) from 7% to 14%.

Maybe this all seems like one big quibble, but to me there are two important take-aways: (1) It’s a myth that Brazil’s s a country driven by commodity exports, and (2) the role of policy credibly needs to be a larger part of the discussion of optimal policy responses to adverse shocks. This may be obvious to someone who has spent a career toggling between EM and DM sovereign analysis, but is regularly absent when DM economists–even great ones like Krugman–go tourist.  (Side note: This is particularly important in all the current chatter surrounding MMT, but that’s a post for another day.)