Lula's Economic Model to Reach its Limit?

The Financial Times has a new article casting doubts on the ability of ex-president Lula's economic model to continue producing strong growth in Brazil.

As defined in the article, the Lula model is the "combination of social welfare hand-outs, generous pay rises, easy access to credit and stable economic management". His "neoliberal" predecessor having righted the economy in the 90s (which was suffering from hyperinflation), the previously radical Lula left the macroeconomic system as it was and introduced a shift in focus from reforming the state to increasing its size and its welfare expenditures on the poor.

The model has worked well until now. Consumer credit has increased drastically over the last decade, but from levels so small that few have seen much risk in them. The increase in welfare has made life better for millions, and the poor spend this money and help keep the economy spinning. And strong confidence in Brazil's economic policies has brought in more foreign investment.

But there are reasons for concern. While loyal followers are prone to babble on with phrases to the tune of "Lula is a better economist than the economists", many refuse to see the important dose of luck that has benefitted the country in recent years, and the FT article does a very good job of pointing this out. Most specifically, Brazil, whose major export is agricultural commodities, has enjoyed years of high growth due largely to booming demand from China (Brazil's biggest trading partner) and other developing markets. In exchange, Brazil imports an incredible amount of consumer goods from China, households become better equipped with furniture and electronics, and people are satisfied as long as things keep growing. But will the commodity boom last forever?

One concern is the relationship between inflation and the value of Brazilian currency. The real has increased in value constantly over the year, as investors have been attracted by high interest rates. The government cannot reduce interest rates due to fears of inflation, so they rely on taxes and other means to reduce the influx of foreign capital. But this maneuver is no longer successful in limiting the real's rise, and Forbes recently reported that the Brazilian government is unlikely to fight the rise of the real effectively given fears of inflation. This will continue to hurt the competitiveness of Brazilian exports.

The FT points out that the state comprises 40% of GDP, but does not confer the same benefits as similarly expensive governments in more developed countries, because it is extremely inefficient. This is most clearly seen in the case of public works projects. The city of Salvador, for example, boasts the most expensive commuter train system in the entire world, per kilometer of track; it was originally alloted R$1 billion to create 41 kilometers of track, but it ended spending that entire amount (and an entire decade of time) to construct 6.7 kilometers, and even then it was not yet functional. The process involved fraud and cartels in the bidding process as well. It is among the worst managed public works projects in the history of mankind. And preparations for the World Cup seem likely to increase the number of public embarrassments. Not only is the country able to muster relatively little money to finance investment, but when it does it simply cannot target the money without bleeding it out to corrupt bureaucrats and their friends. After some reforms made by the presidents prior, one of Lula's legacies will be a commitment to the fast growth of the state, which has expanding to 24 ministries, up from 13 in the 1990s.

Though credit has not traditionally been seen as a threat, that may be beginning to change. A credit watch agency revealed recently a 22% rise in bad loans, and some suspect a possible credit bubble, though the FT notes that loans are far safer and more frequently collateralized in Brazil, reducing the risk. But even if the result is not a crisis, it is at least worth considering that consumers are going to reach their limit and that credit will falter as a contributor to strong growth.

The article does not go into what lies in store as Brazil transitions into an oil economy. But the major lesson of the recent success of Brazil is worth taking into account: luck propelled Brazil in recent years a lot more than most people seem to think. We'll see how Brazil does when its luck changes.