BY jvande | November 30, 2018 | theemergingmarketsinvestor.com
The debate continues on what caused Brazil’s most recent economic crisis, the deepest and longest the country has experienced since the Great Depression.
Nobel Laureate, Paul Krugman, gave his view in his New York Times column a few weeks ago (“What the Hell Happened to Brazil?”, Link). Krugman points to “bad luck” in the form of a severe terms- of- trade shock caused by falling commodity prices, which in turn led to an unwinding of excessive household debt and a severe drop in domestic consumer spending. Brazil, according to Krugman, underwent a debt deflation process, not the typical “sudden stop” emerging market crisis where a build-up in foreign debt reverses when foreign capital abandons a country. The duration and depth of the recession, Krugman believes, were caused by bad policy mistakes: a combination of fiscal austerity and monetary tightening, at a time when Keynesian stimulus could have been effective.
Barron’s Magazine has also chimed into the debate with two articles by Mathew Klein (“Understanding Brazil’s Latest Depression” and “What Triggered Brazil’s Crisis,” Link). Klein points to a massive increase in private debt between 2005-2015 which was accompanied by a large increase in foreign capital inflows, mainly into stocks and bonds. When the capital flows reversed in 2012-14 and the downturn began, the Brazilian authorities tightened both fiscal and monetary policies and deepened the fall, Klein writes echoing Krugman. Klein notes a fiscal adjustment of 5% between 2013 and 2016 (from a surplus of 2% to a deficit of 3%) but still agrees with Krugman that the authorities were too conservative on the fiscal front and focused largely on the tightening of monetary policy to stabilize financial markets.
Both the Krugman and Klein articles are insightful, but I take issue on several points. First, both Klein and Krugman make a glaring omission by not considering political factors. The reelection of President Dilma Rousseff (October 2014) was a great disappointment for the business community and financial markets and probably triggered the start of the recession. At the same time, Brazil entered an enormous political crisis, with the explosion of the “Car Wash” graft probe (initiated in 2014, and still going on)) which implicated hundreds of businessmen and their political cronies. This was soon followed by the impeachment of President Dilma (2015). These unsettling political events certainly played a big role in deepening and extending the downturn.
Second, both Klein and Krugman somewhat mischaracterize the crisis: Krugman, by arguing that Brazil’s woes were more akin to a developed market crisis and could have been alleviated through stepped-up fiscal spending; and Klein, by stating that the commodity cycle (2003-2012) should be considered largely irrelevant to the discussion.
I think the evidence does no support Krugman’s idea. In fact, the crisis should be seen as a garden-variety boom-to-bust emerging market crisis. This is clear if we put the event in the context of the many EM crises of the past decades. Ray Dalio’s book Principles for Navigating Big Debt Crises(Link) provides a good account of the record. Dalio’s “Economic Machine” concept is that financial crises are linked to debt cycles which evolve in predictable patterns and all go through three phases: the bubble build-up, the depression adjustment and the reflationary recovery. Dalio looks at the specifics of 48 crises, 23 of which occured in major emerging markets and are summarized in the chart below. Brazil’s latest crisis is not included in Dalio’s book but I have added it for comparative purposes. The chart shows each country’s characteristics at the peak of the boom cycle in terms of the following criteria:
- Expansion of the Debt to GDP Ratio of at least 5%
- Foreign Debt to GDP of at Least 30%
- Fiscal Deficit at least 2% of GDP
- GDP Output Gap of at least 5% (GDP 5% over trend growth)
- Currency at least 10% overvalued
- Current Account Deficit over 3% of GDP
When a country meets most of these criteria its economy is considered very overheated and vulnerable to a serious downturn.