Uphill Momentum: Brazil’s current macroeconomic stage — part II

In an article published early september, a few weeks after the second quarter (Q2) Gross Domestic Product (GDP) results had been made public by the Instituto Brasileiro de Geografia e Estatística (IBGE), I argued: considering how sensitive the external scenerio presents itself and how much Brazil’s reform agenda lingers on the fate of its volatile and corruption-ridden political caste, the +2% GDP growth forecast for 2020 is all, but sound. I brought that text to an end by saying that, all things taken into account, Brazil’s GDP growth rate for 2020 would possibly fall within a 1 and 1.5% range. Definitely not past the 2% range.

In today’s text I would like to make the case as to why I still uphold my 1–1.5% growth range for Brazil’s 2020 GDP. I am going to do it by outlining the paramount importance of what I like to call entrepreneurial investments for an economy’s long-term growth. My premise here is not novel. It basically states this: that an economy’s growth capacity over the long-term is dependent (albeit not uniquely) on a sustainable and increasing level of entrepreneurial investments.

To do that I am going to draw on a handful of macroeconomic concepts, namely:

The differences between Potential and Effective Gross Domestic Product (P-GDP and E-GDP) coupled with the Real Business Cycle (RBC). I provided a detailed explanation on both RBC and P-GDP vs. E-GDP in my early september text. Basing my argument on the dynamics observed among P-GDP, E-GDP and the RBC should allow me to explain how an economy tends to fluctuate in the short-term* while boasting a linear, upward trending growth curve over the long-term.

Once those initial key concepts have been recalled I am then going to bring in the Production Possibility Curve (PPC). This theory should lead us to two important conclusions: (1) the possibilities of production of an economy given its present growth capacity and (2) the importance of entrepreneurial investments in the expansion of an economy’s production possibilities.

The explanation and figures I am going to provide along with these concepts (P-GDP, E-GDP, RBC and PPC) should be enough to make my case as to why I do not believe that any growth above 1.5% is within Brazil’s reach in 2020.

*A remark ought to be made here. GDP fluctuations in the short- and long-term are vast areas of inquiry in economics. In this text I am mostly going to talk about the long-term. The short-term fluctuations of GDP will delt with in an upcoming text.

  1. Gross Domestic Product (Potential vs. Effective) and the Real Business Cycle theory

Gross Domestic Product, or GDP, is an jargon in economics that is just as widely known as it is misunderstood by the general public. Let us then start with an elementary definition. Any economics textbook defines GDP as the market value of all finished goods and services produced within a country’s border in a period of time, generally a year.

I have purposefully added italics to “goods and services”. In a sense, GDP is just a way of measuring, in any currency — but preferably in US Dollar, because it’s a currency that’s long proved its economic soundness — the total production (i.e. output) of all goods and services that an economy was capable of producing during a period of time.

The fact that GDP can be measured “in any currency” means that what really matters, when it comes to reading GDP figures, is to check how many more goods and services were produced in, say, this year compared to last year’s total output. Out of that analytical reading important and revealing questions can be posed. For instance: has production increased? Has it decreased? Has it flattened out? Has it not grown at all? Policimakers are mostly concerned with a sustained GDP growth rate, because, theoretically, higher GDP is equated with higher standards of living.

In this sense, ideally, GDP should grow constantly and sustainably along time, that is — every following year’s production being higher than the previous’ and at constant price levels (low inflation). What effectively happens, however, is a growth curve that is often punctuated by highs and lows. The early 20th century economists observed that trend/cycle. What ensued was the so-called Real Business Cycle theory (RBC), shown below.

The RBC theory depicts how an economy tends to behave throughout the long-term
The RBC theory depicts how an economy tends to behave throughout the long-term

Real GDP (when inflation is factored out by measuring it at constant, not current, price levels) is depicted on the vertical axis while time is placed on the horizontal axis. The blue, linearly ascending line is Potential-GDP (P-GDP) and the wavy one is Effective GDP (E-GDP).

P-GDP is what the economy is capable of producing as a function of its current stock levels. Stock levels are “ingredients” such as capital, labour and land. Think of those ingredients as a bakery that is equipped with the necessary machinary, capital and labour with which to produce 10 loaves of bread per day. The aggregate of those machinery, capital and labour is what constitutes the bakery’s stock levels which, in turn, allows for its Potential GDP of 10 loaves of bread/day.

E-GDP, on the other hand, is what the economy can effectively produce. Despite the bakery’s daily potential output of 10 loaves of bread, that does not ensure that 10 loaves of bread will be produced on a daily basis. Just as in a bakery, a country’s E-GDP fluctuations is triggered by a number of different reasons. These can either be of an exogenous nature (coming from outside the country’s borders) or of an endogenous nature (stemming from within the country’s borders).

The RBC, among other observations, sheds light on the fact that throghout the short-term an economy (i.e. a country’s level of output) tends to behave in a pattern that is punctuated by four phases: the slowdown or contraction phase; the trough phase; the recovery or expansion phase; and the peak phase.

In the slowdown or conctraction phase the economy is either growing at a slower pace compared to a certain period of time or it is presenting negative growth. When in a trough phase an economy has theoretically hit the bottom. What follows an all-time low GDP performance is the recovery phase, which is when GDP starts to pick up again.

Recovery is not expansion. An economy will have expanded when real growth has been added. Let me offer an analogy. Imagine you owned a ten-room house in 2010. A hurricane hit your place in 2011 and brought down 2 rooms. The size of your home then decreased! In 2012 you managed to rebuild those two lost rooms. You recovered. Had you managed to build a third room we’d have said you expanded. Recovery is not expansion!

Finally, what ensues the expansion period is the peak. That is when the economy seems to have flattened out. Just as a trough preceeds a rebound, a peak might herald the beginning of a slowdown because, historically, that is what the trend has suggested.

Having extablished what the theory says, let us take a look at some actual figures in at attempt to see how well it can describe real world economies.

Below I’ve gathered Real GDP data from 1996 to 2018 of three developing economies (Brazil, Bolivia and Colombia) and three developed economies (the USA, the UK and France). Two things come out visibly: (1) the cycle of contraction-trough-recovery-peak can be easily observed accross all graphs. This partially underpins the theory underlyning the RBC, but it is important to note that just like any social science theory, the RBC is still under development. It roughly, but sufficiently explains how economies tend to behave because of how they have behaved in the past

Another thing that pops out of the graphs below is that (2) the cycle is more recurrent in developing economies. Not surprisingly these are economies with a decades-long record of volatility. Very often these market pertubations have been triggered by internal (endogenous) political instability coupled, at times, with beyond-borders causes (exegenous).

Let us zoom in on Brazil. Note (above) how Brazil exhibts a more recurrent Business Cycle. In the graph below, Real GDP (yearly %) is depicted throughout the 2005–2010 cycle. A number of factors can roughly explain the cycle, such as the 2000’s commodities price boom and overall favarouble foreign conditions (i.e. China and India’s rising internal demand). These were the exogenous causes. The endogenous ones can be boiled down to stimulative monetary policies enacted as an attempt to weather through the 2008 crises and which garanteed a continued expansion of aggregate demand (especially family consumption).

“From 2000 to 2012, Brazil had one of the fastest growing major economies in the world. However, the foundations for this growth were first laid down in 1994 with the Real Plan, which successfully curbed hyperinflation in the country through the creation of a new currency (the real), the deindexation of the economy, the tightening of monetary policy and the floating of its currency. The Real Plan managed to reduce monthly inflation rates of around 50% in January 1994 to 1.71% per month by the end of 1994. Brazil’s economic boom owes much to the commodity super-cycle of the mid-2000s, a wave that Brazil continued to ride until the end of 2012. Brazil was able to utilise its large reserves of raw materials coupled with lower labour and production costs to profit from a high demand of raw materials from the growing economies of China and India3. Furthermore, after the 2008 financial crisis, global liquidity entered emerging markets like Brazil and further boosted the country’s economy . (link)

Having recalled what the Real Business Cycle can tell us and the difference between Potential and Effective GDP, as well as framed it all with actual figures, what you, reader, ought to take away from all that’s been written is this:

Generally speaking, Potential GDP indicates an economy’s growth capability in the long-haul, whereas Effective GDP shows us growth fluctuations in the short-term (at the present time) as it is constrained by manifold endogenous and exogenous factors. That is a very important difference to keep in mind!

That said, let us now understand what economies generally do to expand their level of output along time. To do that I am going to use the Production Possibility Curve (PPC) and show how a specific sort of investment (the entrepreneurial one) can allow for the expansion of a country’s GPD.

2. The Production Possibility Curve & the relevance of Entrepreneurial Investments for an economy: how does GDP tend to behave in the long-run?

The importance of entrepreneurial investments is unquestionable for the economy’s long-term growth capability. “Entrepreneurial investiment” is the type of investiment that is channelled into the acquisition of new machinery, tools, the hiring of labour force, the learning of a new set of skills, etc. Those are things that can allow a country to produce more goods and services. When you, the bakery owner, puts some of your savings into the acquisition of new machinery and the hiring of more employees, for example, you’re adding to your levels of stock and, thus, expanding your bakery’s bread production capability. In a nutshell: entrepreneurial investments allows for the expansion of Potential GDP.

The theory of the Production Possibility Curve (PPC), below, aids us at the understanding and visualisation of the importance of entrepreneurial invesements in an economy. On the vertical axis is the production of capital goods (machinery and tools, goods that can produce other goods) while consumer goods (pizzas, regular cars, video-games, luxury goods, etc.) are placed on the horizontal axis. From an economic standpoint, opting for the production of the former over the latter is a more rational decision, because capital goods allows for the production of more goods. The PPC, then, states that one and only one out of those two production possibilities (capital or consumer goods) can be chosen and that producing one extra unit of a capital good implies forgoing the production of a unit of consumer good.

Another key insight provided by the PPC are the dynamics of the curves. The blue line represents the present’s production capability. Whichever good is chosen over the other, the possibility of production is limited to the present’s capability. Please, note that this blue lines thus represents Potential GDP. The green inferior and superior lines, in turn, represent phases when the present’s level of output is below the potential (the inferior line) or above the potential (the superior line).

In this line of thinking, three scenarios can be pinpointed over the PPC and the Real Business Cycle. In scenario (1) note that the economy is at equilibrium. That is the same as saying that supply meets demand. In a situation like this, price fluctuations (i.e. inflation) is under control and anyone who is willing and able to work can find a job. In economics we say that scenario (1) is when the economy is at full employment. In scenario (2) supply has fallen because demand also did. Th economy, then, is underperforming because production levels is below potential. A domino effect ensues and feeds itself: as demand and supply fall, unemployment tends to rise, which once more upsets demand since the aggregate of salaries is now smaller. In scenario (3) demand exceeds supply. The economy is producing above its potential. Firms jostle for the same finite amount of resources (land, labour, capital) and this pressure leads to inflation, hence why economists call scenario (3) an “inflationary gap” also.

Potential GDP (the blue curve in the PPC and the blue line in the RBC) is said to present an upward, linearly ascending trend. Why? Because knowing that the expansion of a country’s growth capacility is dependent on entrepreneurial investiment, policy-makers tend to allocate a share of a country’s resources into the acquisition of new machinery, construction of infrastruture, advancement of technology through research and development, the improvement of education levels, etc. It is also necessary that government meddling is limited so as to foster the creation of a level playing field where entrepreneurship can florish.

In the picture below note how investments timely made in capital goods (those that can be used to produce other goods and services) enabled the outward expansion of the production possibility curve.

The set of graphs below compares Real GDP (green line) and Investments (dark red line) for the 2009–2024 period of five different economies. The blue dashed line starting in 2019 up until 2024 are forecasts. Under closer inspection this can be inferred: investment levels visibly follow GDP growth. It would be too simplistic to claim that GDP growth is uniquely dependent on invesments. Other variables such as household consumption, government spending and net exports make up what is known as aggregade demand. None of them, however, can drive Potential GDP expansion as directly as entrepreneurial investments. Arguably, as is the case in many countries, household consumption can drive entrepreneurial investments, but only in the sense that the increased demand from households signals to firms that more goods and services need to be supplied and, thus, production must be expanded.

Yet another key observation to be made is that the blue, dashed lines indicating the 2019–2024 forecasts all suggest, ceteris paribus, an ascendig path. This is in line with the Potential GDP’s premise that, in the long-term, an economy’s output capability is ascending and this because of an upward trending investment level. At best, these two variables are expected to behave similarly.

If, from the first part of this article, what you were supposed to take away was that Potential GDP means an economy’s growth capability in the long-term while Effective GDP outlines growth oscillations in the short-term, in this second part you’re supposed to cling to this:

It is in any country’s best interest to garantee a sustained, continuous and price-balanced GDP growth along time. To ensure that, countries need to make sure that their stock levels keep increasing in volume and productivity (so that their Potential GDP can increase). Finally, this can only be done through vast sums of entrepreneurial investments, which, in turn, comes mostly from the private sector that looks first and foremost for a level playing field.

Can vs. Will Brazil growth be over 2% in 2020?

“Can” grow has all to do with Brazil’s growth potential. Whether or not Brazil will realise its potential growth over the coming year (2020) and beyond is first and foremost a political riddle (when looked upon from inside. i.e. endogenous) rather than an economic one (despite the recent and favourable reforms). Moreover, the economy at a regional and global levels has been slow-paced. The International Monetary Fund’s most recent World Outlook Report calls it a “synchronised slowdown”.

Put together, these endogenous and exogenous variables should impact Brazil’s overly optimistic growth expectations. At the opening of the current year (2019), for example, some economists would talk about a +2% GDP growth. Twelve months down the road several revisions meant a handful of slashings. Despite this week’s IBGE GDP Q3 release having shown positive results, Real GDP forecast for 2019 still remains well contained below a 1% uptick.

The graph below compares, in dark red bars, the percentage participation of investments in Brazil’s Gross Domestic Product. A green line crisscrosses the bars. That’s Real GDP growth over the same 2009–2024 span.

A few observations can be made: (1) the five-year cycle preeceding the 2014 0,5% GDP nosedive boasted a yearly average 3,2% of GDP growth while investment levels for the same period averaged 16,2%. (2) The 2016 trough, a -3,3% GDP contraction, saw an investment of 15,5% which would fall yet 0,5 p.p. in 2017. That is the lowest level within the 2009–2024 span and 3% below the level observed back in 1995! (3) The five-year cycle forecast starting in 2020 is expected to see investment levels averaging 16% yearly. That is 0,20 p.p. below the pre-crisis 2009–2013 cycle. If conditions do not deteriorate any further, both internally and externally, GDP is expected to average 2,46% over the same five-year span. That is somewhat below the pre-crisis average.

All in all, this is not to say that Brazil will definitely not attain the forecasted figures, but that, taking both endogenous (mostly a corruption-ridden political caste) and exogenous (a syncronised global slowdown, especially China’s, Brazil’s main trading partner), it is highly unlikely that 2020 will see the expected +2% growth. That is why I still uphold my 1–1.5% growth range stance.

An International Relations degree holder; a language, history and economics aficionado; and a soon-to-be Economist who sees writing a thought-untangling act.